Unrelated Business Taxable Income Separately Computed for Each Trade or Business
| Published date | 24 April 2020 |
| Citation | 85 FR 23172 |
| Record Number | 2020-06604 |
| Section | Proposed rules |
| Court | Internal Revenue Service,Treasury Department |
Federal Register, Volume 85 Issue 80 (Friday, April 24, 2020)
[Federal Register Volume 85, Number 80 (Friday, April 24, 2020)]
[Proposed Rules]
[Pages 23172-23199]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-06604]
[[Page 23171]]
Vol. 85
Friday,
No. 80
April 24, 2020
Part III
Department of the Treasury
-----------------------------------------------------------------------
Internal Revenue Service
-----------------------------------------------------------------------
26 CFR Parts 1, 602
Unrelated Business Taxable Income Separately Computed for Each Trade or
Business; Proposed Rule
Federal Register / Vol. 85 , No. 80 / Friday, April 24, 2020 /
Proposed Rules
[[Page 23172]]
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[REG-106864-18]
RIN 1545-BO79
Unrelated Business Taxable Income Separately Computed for Each
Trade or Business
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
-----------------------------------------------------------------------
SUMMARY: This document contains proposed regulations that provide
guidance on how an exempt organization subject to the unrelated
business income tax described in section 511 of the Internal Revenue
Code (Code) determines if it has more than one unrelated trade or
business, and, if so, how the exempt organization calculates unrelated
business taxable income. The proposed regulations also clarify that the
definition of ``unrelated trade or business'' applies to individual
retirement accounts. Additionally, the proposed regulations provide
that inclusions of subpart F income and global intangible low-taxed
income are treated in the same manner as dividends for purposes of
section 512. The proposed regulations affect exempt organizations.
DATES: Written or electronic comments and requests for a public hearing
must be submitted by June 23, 2020.
ADDRESSES: Submit electronic submissions via the Federal eRulemaking
Portal at www.regulations.gov (indicate IRS and REG-106864-18) by
following the online instructions for submitting comments. Once
submitted to the Federal eRulemaking Portal, comments cannot be edited
or withdrawn. The Department of the Treasury (Treasury Department) and
the Internal Revenue Service (IRS) will publish for public availability
any comment received to its public docket, whether submitted
electronically or in hard copy. Send hard copy submissions to:
CC:PA:LPD:PR (REG-106864-18), Room 5203, Internal Revenue Service, P.O.
Box 7604, Ben Franklin Station, Washington, DC 20044.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed rules,
Jonathan A. Carter at (202) 317-5800; concerning submissions of
comments and requests for a public hearing, Regina Johnson at (202)
317-5177 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Under section 501(a) of the Code, organizations described in
sections 401(a) and 501(c) generally are exempt from federal income
taxation. However, section 511(a)(1) imposes a tax (computed as
provided in section 11) on the unrelated business taxable income (UBTI)
of organizations described in section 511(a)(2), which includes
organizations described in sections 401(a) and 501(c) (other than a
trust described in section 511(b) or an instrumentality of the United
States described in section 501(c)(1)), as well as state colleges and
universities. Additionally, section 511(b)(1) imposes a tax (computed
as provided in section 1(e)) on the UBTI of trusts described in section
511(b)(2), which describes trusts that are exempt from federal income
taxation under section 501(a) and which, if it were not for such
exemption, would be subject to subchapter J of chapter 1 of the Code
(relating to estates, trusts, beneficiaries, and decedents).
Organizations described in section 511(a)(2) and trusts described in
section 511(b)(2) are collectively called ``exempt organizations'' or
``organizations'' throughout this preamble, unless otherwise stated.\1\
---------------------------------------------------------------------------
\1\ Section 408(e) states that an individual retirement account
(IRA) is subject to the taxes imposed by section 511. Accordingly,
any reference to an exempt organization in this preamble includes an
IRA, without regard to whether it is a traditional IRA, Roth IRA,
simplified employee pension (SEP-IRA), or savings incentive match
plan for employees (SIMPLE IRA). See section 9 of this preamble for
more information.
---------------------------------------------------------------------------
Definitions of UBTI
Section 512 provides two different definitions of UBTI--one in
section 512(a)(1), which applies to most exempt organizations, and one
in section 512(a)(3), which applies only to social clubs described in
section 501(c)(7), voluntary employees' beneficiary associations
(VEBAs) described in section 501(c)(9), and supplemental unemployment
compensation benefits trusts (SUBs) described in section 501(c)(17).
Section 512(a)(1) defines UBTI as the gross income derived by any
exempt organization from an unrelated trade or business regularly
carried on by it, less the deductions allowed by chapter 1 of the Code
(chapter 1) that are directly connected with the carrying on of such
trade or business, both computed with the modifications described in
section 512(b). Section 513(a) generally defines ``unrelated trade or
business'' as any trade or business the conduct of which is not
substantially related (aside from the need of such exempt organization
for income or funds or the use it makes of the profits derived) to the
exercise or performance by such exempt organization of its charitable,
educational, or other purpose or function constituting the basis for
its exemption under section 501 (or, in the case of a state college or
university, to the exercise or performance of any purpose or function
described in section 501(c)(3)). However, in the case of a trust that
is exempt from tax under section 501(a) and described in section 401(a)
(qualified retirement plans) or section 501(c)(17) (SUBs), section
513(b) defines ``unrelated trade or business,'' as any trade or
business regularly carried on by such trust or by a partnership of
which it is a member. Section 1.513-1(b) generally provides that, for
purposes of section 513, the term ``trade or business'' has the same
meaning as in section 162.
By contrast, section 512(a)(3)(A) defines UBTI as the gross income
(excluding exempt function income), less the deductions allowed by
chapter 1 that are directly connected with the production of the gross
income (excluding exempt function income), both computed with the
modifications described in section 512(b)(6) (net operating loss (NOL)
deduction), (b)(10) (charitable contribution deduction by exempt
organizations), (b)(11) (charitable contribution deduction by certain
trusts), and (b)(12) (specific deduction). Accordingly, UBTI under
section 512(a)(3) is not limited to the gross income derived by an
exempt organization from any unrelated trade or business regularly
conducted by it. Thus, any gross income that is not exempt function
income (nonexempt function income) is UBTI under section 512(a)(3).
Unrelated Trades or Businesses Conducted Indirectly Through Another
Entity
An exempt organization may conduct an unrelated trade or business
directly or indirectly through another entity, such as a partnership
(including any entity treated as a partnership for federal tax
purposes). Section 512(c) provides that, if a trade or business
regularly carried on by a partnership of which an exempt organization
is a partner is an unrelated trade or business with respect to such
exempt organization, the exempt organization includes in UBTI--subject
to the exceptions, additions, and limitations of section 512(b)--its
distributive share of partnership gross income (whether or not
distributed) and partnership deductions directly connected with
[[Page 23173]]
such gross income. See Sec. 1.512(c)-1 (describing how UBTI is
calculated in a situation in which an exempt organization's
distributive share of partnership income consists of both UBTI and
income that is excluded from the calculation of UBTI). In determining
whether a partnership conducts a trade or business that is an unrelated
trade or business with respect to an exempt organization partner, the
exempt organization would use the applicable definition of ``unrelated
trade or business'' in section 513(a) or (b). Section 512(c) applies
regardless of whether an exempt organization is a general or limited
partner. See Rev. Rul. 79-222, 1979-2 C.B. 236.
Calculation of UBTI
An exempt organization may engage in more than one unrelated trade
or business. Prior to the enactment of section 512(a)(6), an exempt
organization deriving gross income from the regular conduct of two or
more unrelated trades or businesses calculated UBTI by determining its
aggregate gross income from all such unrelated trades or businesses and
reducing that amount by the aggregate deductions allowed with respect
to all such unrelated trades or businesses. See Sec. 1.512(a)-1(a).
However, section 512(a)(6), which was added to the Code by section
13702 of Public Law 115-97, 131 Stat. 2054 (2017), commonly referred to
as the Tax Cuts and Jobs Act (TCJA), enacted December 22, 2017, changed
this calculation for exempt organizations with more than one unrelated
trade or business so that, in the case of any exempt organization with
more than one unrelated trade or business:
(A) UBTI, including for purposes of determining any NOL deduction,
shall be computed separately with respect to each trade or business and
without regard to section 512(b)(12) (allowing a specific deduction of
$1,000),
(B) The UBTI of such exempt organization shall be the sum of the
UBTI so computed with respect to each trade or business, less a
specific deduction under section 512(b)(12), and
(C) For purposes of section 512(a)(6)(B), UBTI with respect to any
such trade or business shall not be less than zero.
Thus, under section 512(a)(6), an exempt organization is no longer
permitted to aggregate income and deductions from all unrelated trades
or businesses when calculating UBTI. Section 512(a)(6) applies to
taxable years beginning after December 31, 2017, but not to NOLs
arising before January 1, 2018, that are carried over to taxable years
beginning on or after such date. See section 13702(b) of the TCJA.
In August 2018, the Treasury Department and the IRS issued Notice
2018-67 (2018-36 IRB 409 (Sept. 4, 2018)), which discussed and
solicited comments regarding various issues arising under section
512(a)(6) and set forth interim guidance and transition rules relating
to that section. The Treasury Department and the IRS received 24
comments in response to Notice 2018-67 and considered these comments in
drafting these proposed regulations. Some of these comments discussed
the interaction between section 512(a)(6) and (7), which was also
enacted by the TCJA and provided that an exempt organization's UBTI is
increased by any amount for which a deduction is not allowable under
chapter 1 by reason of section 274 and which is paid or incurred by
such exempt organization for certain disallowed fringes. These comments
are not discussed because section 512(a)(7) was repealed on December
20, 2019. See Further Consolidated Appropriations Act, 2020, Division
Q, Public Law 116-94, 133 Stat. 2534 (2019) (retroactively effective to
date of enactment of the TCJA). The remaining comments are discussed in
the Explanation of Provisions and Comment Summary. The comments are
available for public inspection upon request.
Explanation of Provisions and Summary of Comments
Section 512(a)(6) requires an exempt organization with more than
one unrelated trade or business to first calculate UBTI separately with
respect to each such trade or business, without regard to the specific
deduction generally allowed under section 512(b)(12). The Conference
Report explains that ``[t]he organization's [UBTI] for the taxable year
is the sum of the amounts (not less than zero) computed for each
separate trade or business, less the specific deduction allowed under
section 512(b)(12).'' H.R. Rep. No. 115-466 (2017), at 548. Section
512(a)(6) continues to allow an NOL deduction, but ``only with respect
to a trade or business from which the loss arose.'' Id. Thus, the
legislative history states that ``a deduction from one trade or
business for a taxable year may not be used to offset income from a
different unrelated trade or business for the same taxable year.'' Id.
at 548. Because section 512(a)(6) disallows the aggregation of income
and deductions from all unrelated trades or businesses, these proposed
regulations revise Sec. 1.512(a)-1(a) to state that, in the case of an
organization with more than one unrelated trade or business, UBTI is
calculated separately with respect to each such trade or business as
provided in new proposed Sec. 1.512(a)-6.
Congress did not provide explicit criteria for determining whether
an exempt organization has ``more than one unrelated trade or
business'' or how to identify ``separate'' unrelated trades or
businesses for purposes of calculating UBTI in accordance with section
512(a)(6).\2\ Accordingly, these proposed regulations establish the
method for determining whether an exempt organization has more than one
unrelated trade or business for purposes of section 512(a)(6) and
identifying separate unrelated trades or businesses for purposes of
calculating UBTI under this section. These proposed regulations also
clarify that, for purposes of the unrelated business income tax
generally and the application of section 512(a)(6) specifically, an
individual retirement plan (IRA) described in section 408(e) uses the
definition of ``unrelated trade or business'' in section 513(b)
applicable to trusts. Additionally, these proposed regulations clarify
that inclusions of subpart F income under section 951(a)(1)(A) and
global intangible low-taxed income (GILTI) under section 951A(a) are
treated in the same manner as dividends for purposes of section
512(b)(1).
---------------------------------------------------------------------------
\2\ The Joint Committee on Taxation's General Explanation of
Public Law 115-97 states that ``it is intended that the Secretary
issue guidance concerning when an activity will be treated as a
separate unrelated trade or business for purposes of [section
512(a)(6)].'' Staff of the Joint Committee on Taxation, General
Explanation of Public Law 115-97 (December 2018), at 293.
---------------------------------------------------------------------------
1. Separate Unrelated Trade or Business
There is no general statutory or regulatory definition of what
activities constitute a ``trade or business'' for purposes of the Code.
Whether an activity constitutes a trade or business may vary depending
on which Code section is involved. See generally Commissioner v.
Groetzinger, 480 U.S. 23, 27 (1987). Section 1.513-1(b) of the current
Treasury regulations (promulgated in 1967) states that, ``for purposes
of section 513, the term `trade or business' has the same meaning it
has in section 162, and generally includes any activity carried on for
the production of income from the sale of goods or performance of
services.''
Notice 2018-67 permitted a reasonable, good-faith interpretation of
sections 511 through 514, considering all the facts and circumstances,
when determining whether an exempt organization has more than one
unrelated trade or business for purposes
[[Page 23174]]
of section 512(a)(6). At the same time, Notice 2018-67 stated that the
Treasury Department and the IRS were considering the use of the North
American Industry Classification System (NAICS) codes as a method for
determining whether an exempt organization has more than one unrelated
trade or business for purposes of section 512(a)(6) and for purposes of
calculating UBTI under section 512(a)(6)(A). NAICS is an industry
classification system for purposes of collecting, analyzing, and
publishing statistical data related to the United States business
economy that results from a cooperative effort between Canada, Mexico,
and the United States. See Executive Office of the President, Office of
Management and Budget, North American Industry Classification System
(2017) (2017 NAICS Manual), available at https://www.census.gov/eos/www/naics/2017NAICS/2017_NAICS_Manual.pdf. The structure of NAICS is
hierarchical, using a six-digit coding system. Id. at 16, 18, & 20.
NAICS divides the economy into 20 sectors. Id. at 3. The first two
digits of the code designate the sector, each of which represents a
general category of economic activity, including retail trade (44-45);
real estate and rental and leasing (53); health care and social
assistance (62); and accommodation and food services (72). Id. at 16 &
20. The third digit designates the subsector; the fourth digit
designates the industry group; and the fifth digit designates the NAICS
industry. Any establishment is usually classified down to the NAICS
five-digit industry level classification, using the classification of
the industry that best matches its primary activity. When applicable,
the sixth digit is used to designate the national industry, to reflect
differences between the countries. A zero as the sixth digit generally
indicates that the NAICS industry and the U.S. industry are the same.
Id. at 18. Accordingly, each digit of the NAICS 6-digit codes describes
an industry with increasing specificity.
In Notice 2018-67, the Treasury Department and the IRS provided
that a reasonable, good-faith interpretation included using the most
specific level--six-digit codes (NAICS 6-digit codes). The Treasury
Department and the IRS also requested comments regarding rules to
identify separate trades or businesses that achieve the intent of
Congress in enacting section 512(a)(6) and that are administrable for
exempt organizations and the IRS. As discussed further in section 1.a
of this preamble, methods commenters suggested included devising a
facts and circumstances test along with a clearly defined safe harbor,
adopting principles described in various Code sections (including
sections 183 and 469), using the groupings described in Form 14018,
``Compliance Questionnaire Colleges and Universities,'' and using less
than six digits of the NAICS codes.
After considering the comments, the Treasury Department and the IRS
continue to view an identification method based on NAICS codes as
administrable for exempt organizations and the IRS. Moreover, in
response to comments regarding the burden related to the specificity of
NAICS 6-digit codes, the proposed regulations provide that an exempt
organization generally will identify its separate unrelated trades or
businesses using the first two digits of the NAICS codes (NAICS 2-digit
codes).
a. The North American Industry Classification System (NAICS)
Most commenters that discussed NAICS supported using the NAICS
codes to identify separate unrelated trades or businesses for purposes
of section 512(a)(6). Nonetheless, several commenters generally opposed
this proposed method. These commenters argued that the NAICS codes were
not created to define ``trade or business'' for UBTI purposes and
therefore fail to sufficiently describe the full range of possible
unrelated trades or businesses engaged in by exempt organizations.
While the Treasury Department and the IRS recognize that the NAICS
codes were not specifically designed for use under section 512(a)(6),
the Treasury Department and the IRS continue to believe that using the
NAICS codes is appropriate because NAICS ``is a comprehensive
[classification] system covering all economic activities.'' 2017 NAICS
Manual, at 14. Additionally, the broad scope of activities covered by
the NAICS 2-digit codes should cover all the unrelated trade or
business activities conducted by exempt organizations.
The NAICS codes were developed, in coordination with Canada and
Mexico, by the Office of Management and Budget (OMB) and are managed by
the United States Census Bureau. The OMB reviews and updates the NAICS
codes as appropriate every five years and, at times, may remove codes.
Id. at 78. In responding to the NAICS 6-digit codes discussed in Notice
2018-67, some commenters expressed concern that the Treasury Department
and the IRS do not control NAICS and that this could adversely impact
organizations using the codes for tax purposes. The Treasury Department
and the IRS view the proposal to use NAICS 2-digit codes as addressing
this concern because the codes are revised through notice and comment
rulemaking, and OMB has never revised the codes at the 2-digit level.
A few commenters noted that a recent report by the Treasury
Inspector General for Tax Administration (TIGTA) determined that the
NAICS codes are ``unreliable for use to identify businesses that may be
subject to excise tax reporting and payment.'' Treasury Inspector
General for Tax Administration, The Affordable Care Act: An Improved
Strategy is Needed to Ensure Accurate Reporting and Payment of the
Medical Device Excise Tax 5 (Jul. 17, 2014). The Treasury Department
and the IRS consider the situation addressed by the TIGTA report to be
distinguishable from the use of the NAICS 2-digit codes to identify
separate unrelated trades or businesses for purposes of section
512(a)(6). The TIGTA report addressed the IRS's efforts to determine
the population of taxpayers subject to the new medical device excise
tax based on the NAICS 6-digit code a taxpayer had reported on Schedule
K, ``Other Information,'' of Form 1120, ``U.S. Corporation Income Tax
Return'' to identify the activity from which it derives the largest
percentage of total receipts. TIGTA found that not every medical device
manufacturer used the same NAICS 6-digit code to report the activity,
such that reliance on one NAICS 6-digit code would not identify all
businesses that may be subject to the tax. TIGTA also noted that the
NAICS 6-digit code did not always signify a business that is engaged in
taxable sales of medical devices. Here, an exempt organization will be
reporting each of its separate unrelated trades or businesses using the
more general NAICS 2-digit codes on Form 990-T, ``Exempt Organization
Business Income Tax Return,'' for the purpose of ensuring compliance
with section 512(a)(6). As previously discussed, the NAICS 2-digit code
describes a broader sector of the economy, making it more likely that
taxpayers engaged in similar activities that could be described in more
than one NAICS 6-digit code will nonetheless report those activities as
part of the same overall sector.
i. NAICS 2-Digit Codes
As discussed in section 1 of this preamble, Notice 2018-67
permitted reliance on NAICS 6-digit codes as a method of identifying
separate trades or businesses and requested comments regarding whether
use of less than six digits of the NAICS codes, either alone or in
combination with one or more other methods, would appropriately
[[Page 23175]]
identify separate trades or businesses for purposes of achieving the
objectives of section 512(a)(6). Nearly all the commenters making
recommendations on the NAICS codes rejected the use of NAICS 6-digit
codes. These commenters noted that using NAICS 6-digit codes would
result in significant administrative burden because an exempt
organization would have to determine which of over 1,000 NAICS 6-digit
codes most accurately describes its trades or businesses. Commenters
noted that many NAICS 6-digit codes may apply to more than one trade or
business activity or that no NAICS 6-digit code may exist to accurately
describe a trade or business activity. Additionally, these commenters
argued that the use of NAICS 6-digit codes could potentially require an
exempt organization to split what has traditionally been considered one
unrelated trade or business activity into multiple trades or
businesses.
Half of the commenters making recommendations on the NAICS codes
suggested adoption of NAICS 2-digit codes, which would identify trades
or businesses in 20 sectors. These commenters generally explained that
use of NAICS 2-digit codes would result in broader, less subjective
identification of trades or businesses that would naturally permit the
aggregation of similar activities. Furthermore, one of these commenters
stated that the use of fewer digits of the NAICS codes would minimize
implementation costs and reduce the administrative burden on the IRS as
well as exempt organizations. This commenter opined that the NAICS 2-
digit codes are less likely to change over time than the NAICS codes
with more digits because the specificity of the NAICS codes increases
as digits are added. NAICS 3-digit codes, which one commenter
recommended adopting, identify 99 subsectors. By contrast, NAICS 4-
digit codes, which two commenters recommended adopting, identify 311
industry groups.
The Treasury Department and the IRS recognize that limitations
exist in using NAICS as a method of identifying an exempt
organization's separate unrelated trades or businesses. However, the
Treasury Department and the IRS conclude that adopting the NAICS 2-
digit codes will minimize those limitations and that NAICS 2-digit
codes are less likely to change over time than NAICS codes with more
digits. At the same time, adoption of NAICS 2-digit codes will not
allow the offsetting of losses between the 20 sectors of unrelated
trades or businesses. Additionally, under existing precedent, an
organization must determine whether an activity is an ``unrelated trade
or business'' within the meaning of section 513 before it determines
what NAICS 2-digit code describes that ``separate'' unrelated trade or
business. An organization cannot use losses from an activity that
consistently generates losses to offset income from a profitable trade
or business unless the organization can show that the loss-producing
activity is conducted with the requisite profit motive. See Portland
Golf Club v. Commissioner, 497 U.S. 154, 164 (1990) (confirming that,
``[a]lthough [section 162] does not expressly require that a `trade or
business' must be carried on with an intent to profit, this Court has
ruled that a taxpayer's activities fall within the scope of [section]
162 only if an intent to profit has been shown'' and citing
Groetzinger, 480 U.S. at 35); Losantiville Country Club v.
Commissioner, 906 F.3d 468, 473-75 (6th Cir. 2018) (demonstrating
profit motive without reference to profitability by applying section
183 factors).
Furthermore, the Treasury Department and the IRS conclude that use
of NAICS 2-digit codes results in broader identification of trades or
businesses that will minimize implementation costs and will mitigate
the administrative burden on exempt organizations and the IRS that
would be imposed by more detailed NAICS codes. The use of NAICS 2-digit
codes should also reduce any inequity that might result from a code
system that was not specifically designed to describe the business
activities of exempt organizations.
For these reasons, the proposed regulations generally provide that
an exempt organization will identify each of its separate unrelated
trades or businesses using the first two digits of the NAICS code that
most accurately describes a trade or business. The Treasury Department
and the IRS request comments on whether another method, or additional
methods, of identifying an exempt organization's separate unrelated
trades or businesses better achieves the intent of Congress in enacting
section 512(a)(6) while still being administrable for exempt
organizations and the IRS.
A few commenters requested confirmation that the Treasury
Department and the IRS will permit an exempt organization to rely on
the NAICS code that describes all the activities of the organization.
For example, NAICS describes educational services, which includes
colleges, universities, and professional schools, under one NAICS 2-
digit code (61).
An unrelated trade or business generally is any trade or business
the conduct of which is not substantially related to the exercise or
performance by such exempt organization of its charitable, educational,
or other purpose or function constituting the basis for its exemption
under section 501. See section 513(a). A NAICS code that describes all
of an exempt organization's activities, even those activities that are
substantially related to the exercise or performance of the exempt
organization's exempt function, fails to identify the exempt
organization's unrelated trades or businesses and undermines the
Congressional intent in enacting section 512(a)(6). Accordingly, the
proposed regulations clarify that the NAICS code chosen must identify
the unrelated trade or business in which the exempt organization
engages (directly or indirectly) and not the activities the conduct of
which are substantially related to the exercise or performance by such
exempt organization of its charitable, educational, or other purpose or
function constituting the basis for its exemption under section 501
(or, in the case of an exempt organization described in section
511(a)(2)(B), to the exercise or performance of any purpose or function
described in section 501(c)(3)). Thus, returning to the previous
example, a college or university cannot choose NAICS code 61 for all
its unrelated trade or business activities.
Similarly, one commenter requested that the Treasury Department and
the IRS confirm that a qualified retirement plan can use the NAICS code
describing employee benefit funds, which is included under the NAICS 2-
digit code for finance and insurance (52), to describe all the plan's
unrelated trades or businesses. As discussed in the Background section,
qualified retirement funds are subject to the general definition of
UBTI in section 512(a)(1) but the term ``unrelated trade or business''
is defined in a special rule for trusts under section 513(b) as ``any
trade or business regularly carried on by such [plan] or by a
partnership of which it is a member.'' Accordingly, it must use the
NAICS 2-digit code that most accurately describes the underlying trade
or business regularly carried on by the plan or by a partnership of
which it is a member. However, it appears that qualified retirement
plans generally derive most, if not all, of their UBTI from investment
activities, the identification of which is discussed in section 2 of
this preamble, and which includes UBTI from any qualifying partnership
interests (see section 2.d of
[[Page 23176]]
this preamble) or qualifying S corporation interests (see section 4.a
of this preamble). Accordingly, unless a qualified retirement plan
engages directly in one or more unrelated trades or businesses or has
non-qualifying partnership interests or non-qualifying S corporation
interests, a qualified retirement plan will not be subject to section
512(a)(6) because it will only have one unrelated trade or business for
purposes of section 512(a)(6)--its investment activities.
A social club described in section 501(c)(7) would not be able to
use the NAICS 2-digit code for arts, entertainment, and recreation
(71), which includes golf courses and country clubs, to identify all
its unrelated trades or businesses. As explained in the Background
section, social clubs are subject to the definition of UBTI in section
512(a)(3), which defines UBTI, in part, as ``gross income (excluding
exempt function income)'' and does not refer directly to ``any
unrelated trade or business.'' However, as further explained in section
5 of this preamble, these proposed regulations apply regardless of
whether an organization is subject to the definition of UBTI in section
512(a)(1) or section 512(a)(3). Accordingly, a social club must use the
NAICS code that most accurately describes its unrelated trade or
business activities. The social club may use the NAICS 2-digit code for
arts, entertainment, and recreation (71) only to the extent such code
describes its unrelated trades or businesses, such as rounds of golf
played by nonmembers, the greens fees for which would result in UBTI.
At least one commenter recommended that the proposed regulations
permit an exempt organization to aggregate trades or businesses that
may be described by multiple NAICS codes as a single trade or business
when those activities are closely related, similar in nature, and
essentially conducted as a single trade or business. Although the
Treasury Department and the IRS recognize that the use of more digits
of the NAICS codes could result in the division of business activities
traditionally conducted as one unit into more than one trade or
business, the use of NAICS codes at the 2-digit level, as noted by
other commenters, results in the aggregation of trades or businesses in
the same economic sector. Accordingly, the Treasury Department and the
IRS address this comment by adopting the use of NAICS 2-digit codes.
ii. Codes Reported Only Once
The Treasury Department and the IRS recognize that an exempt
organization can have a trade or business that it operates in
different, geographic areas. For example, a hospital organization may
operate several hospital facilities in a geographic area (or multiple
geographic areas), all of which include pharmacies that sell goods to
the general public. See Rev. Rul. 68-375, 1968-2 C.B. 245. Pharmacies
are described under the NAICS 2-digit code for retail trade (44).
Although each pharmacy potentially could be considered a ``separate''
trade or business under section 512(a)(6), particularly if separate
books and records exist for each pharmacy, the Treasury Department and
the IRS recognize that devising rules to distinguish between each
pharmacy trade or business would introduce additional complexity and
increase the administrative burden on the hospital organization.
Accordingly, the proposed regulations provide that an exempt
organization will report each NAICS 2-digit code only once. Thus, even
though the hospital organization in the previous example operates more
than one pharmacy, the hospital organization would report all the
pharmacies using the NAICS 2-digit code for retail trade (44), along
with any other retail trades or businesses described by this NAICS 2-
digit code, on Form 990-T as one unrelated trade or business.
iii. Erroneous Codes
The proposed regulations provide that, once an exempt organization
has identified a separate unrelated trade or business using a
particular NAICS 2-digit code, the organization may not change the
NAICS 2-digit code describing that trade or business unless the
organization can show that the NAICS 2-digit code chosen was due to an
unintentional error and that another NAICS 2-digit code more accurately
describes the trade or business. This limitation will apply to codes
reported on the first Form 990-T filed after final regulations under
section 512(a)(6) are published in the Federal Register. The Treasury
Department and the IRS anticipate that the instructions to the Form
990-T will be revised to describe how an exempt organization provides
notification of such an error. Additionally, the Treasury Department
and the IRS request comments regarding whether there are other
circumstances in which an exempt organization should be permitted to
change NAICS 2-digit codes.
b. New Identification Methods
At least two commenters suggested that the proposed regulations
permit the Treasury Department and the IRS the flexibility to add new
methods of identifying separate unrelated trades or businesses through
guidance published in the Internal Revenue Bulletin. The Treasury
Department and the IRS recognize that other code systems may exist (and
have not yet been identified) or may be devised in the future that
better reflect the unrelated trade or business activities engaged in by
exempt organizations. However, the Treasury Department and the IRS also
expect that the proposed regulations provide a method of identifying
separate unrelated trades or businesses that is administrable for
exempt organizations and the IRS and therefore do not anticipate the
need to routinely modify that method. As more experience is gained over
time with the administration of section 512(a)(6), the Treasury
Department and the IRS may consider additional identification methods,
including the use of code systems or indices other than NAICS, and will
publish guidance as needed.
c. De Minimis Exceptions
One commenter recommended that the Treasury Department and the IRS
adopt a de minimis exception for exempt organizations reporting less
than $100,000 of gross UBTI. Relying on statistical data published by
the IRS, the commenter states that such organizations were responsible
for only five percent of the total unrelated business income tax paid
in 2013. This commenter argued that small exempt organizations likely
lack the internal staff and the resources to implement the changes
required by the enactment of section 512(a)(6) and to engage outside
professionals to assist with ongoing compliance with that section.
As a result of the commenter's proposed threshold, section
512(a)(6) would not apply to more than 80 percent of the exempt
organizations filing Form 990-Ts (based on the statistical data cited
by the commenter). See Table 4. Unrelated Business Income Tax Returns:
Returns with Positive Unrelated Business Taxable Income: Number of
Returns, Gross Unrelated Business Income (UBI), Total Deductions,
Unrelated Business Taxable Income, and Total Tax, by Type of Entity and
Size of Gross UBI Tax Year 2013, available at https://www.irs.gov/statistics/soi-tax-stats-exempt-organizations-unrelated-business-income-ubi-tax-statistics#2. Accordingly, a supposed ``de minimis''
[[Page 23177]]
rule with a $100,000 gross UBTI threshold would effectively render
section 512(a)(6) a nullity for most exempt organizations.
More importantly, as noted by the commenter, section 512(a)(6) does
not provide a de minimis rule and does not provide discretionary
authority for the Treasury Department and the IRS to establish one.
Accordingly, even at a lower threshold, a de minimis rule would be
contrary to the stated Congressional intent of not permitting exempt
organizations to use losses from one unrelated trade or business to
offset the gains from another unrelated trade or business. However, the
Treasury Department and the IRS note that the use of NAICS 2-digit
codes, along with the treatment of an exempt organization's investment
activities as one unrelated trade or business (as described in section
2.a of this preamble), is expected to address many of the concerns
prompting the request for a de minimis rule because smaller entities
are not as likely to have more than one unrelated trade or business.
The Treasury Department and the IRS therefore do not adopt this
comment.
d. Allocation of Directly Connected Deductions
i. In General
Section 512(a)(1) permits an exempt organization with an unrelated
trade or business to reduce the income from that trade or business by
the deductions allowed by chapter 1 that are directly connected with
the carrying on of such trade or business. To be ``directly connected''
with a trade or business, an item of deduction must have a proximate
and primary relationship to the carrying on of the unrelated trade or
business generating the gross income. See Sec. 1.512(a)-1(a).
Expenses, depreciation, and similar items attributable solely to the
conduct of an unrelated trade or business are proximately and primarily
related to that trade or business and qualify to reduce income from
such trade or business under section 512(a)(1) to the extent such items
meet the requirements of sections 162 (trade or business expenses), 167
(depreciation), and other relevant provisions. To the extent that an
exempt organization may have items of deduction that are shared between
an exempt activity and an unrelated trade or business, Sec. 1.512(a)-
1(c) provides special rules for allocating such expenses. For example,
if facilities are used both to carry on exempt activities and to
conduct unrelated trade or business activities, then expenses,
depreciation, and similar items attributable to such facilities must be
allocated between the two uses on a reasonable basis. See Sec.
1.512(a)-1(c).\3\
---------------------------------------------------------------------------
\3\ The same method used for allocating expenses in determining
taxable income must also be used when determining whether an
activity is conducted with the intent to profit, and thus (as
discussed further in section 5.b.iv of this preamble) whether such
activity is a trade or business. Portland Golf Club v. Commissioner,
497 U.S. 154, 171 (1990) (stating that ``in demonstrating the
requisite profit motive, Portland Golf must employ the same method
of allocating fixed expenses as it uses in calculating its actual
loss'').
---------------------------------------------------------------------------
The allocation issues under section 512(a)(1) are also relevant
under section 512(a)(6) because an exempt organization with more than
one unrelated trade or business must not only allocate indirect
expenses among exempt and taxable activities as described in Sec.
1.512(a)-1(c) but also among separate unrelated trades or businesses.
Accordingly, Notice 2018-67 stated the Treasury Department and the IRS
are considering modifying the underlying reasonable allocation method
in Sec. 1.512(a)-1(c) and providing specific standards for allocating
expenses relating to dual use facilities and the rules under section
512(a)(6). Notice 2018-67 requested comments regarding possible rules
or defined standards for the allocation of indirect expenses between
separate unrelated trades or businesses for purposes of calculating
UBTI under section 512(a)(6)(A), and regarding what allocation methods
should be considered ``reasonable.''
The three commenters addressing allocation methods generally
recommended retaining the current ``any reasonable method'' approach.
Nonetheless, one of these commenters recommended that the Treasury
Department and the IRS adopt existing cost allocation rules set forth
by the OMB, referred to as the Uniform Administrative Requirements,
Cost Principles, and Audit Requirements for Federal Awards (2 CFR 200),
and by the Financial Accounting Standards Board in the Accounting
Standard Update 2016-14, both of which require allocations to be made
``on a rational, reasonable, and objective basis across functional
expense categories.'' Another commenter recommended adopting accounting
methods specific to social club activities, such as a golf.
The Treasury Department and the IRS are concerned that permitting
allocation methods based solely on reasonableness is difficult for the
IRS to administer and may not provide certainty for taxpayers. Whether
an allocation method is ``reasonable'' depends on all the facts and
circumstances. See Rensselaer Polytechnic Institute v. Commissioner, 79
T.C. 967 (1982), aff'd 732 F.2d 1058 (2d Cir. 1984) (finding an
allocation method based on actual use to be ``reasonable'' within the
meaning of Sec. 1.512(a)-1(c)). The Treasury Department and the IRS
continue to consider the allocation issue and intend to publish a
separate notice of proposed rulemaking providing further guidance on
this issue. Until publication of a separate notice of proposed
rulemaking, these proposed regulations incorporate the existing
allocation standard in Sec. 1.512(a)-1(c), which provides that an
exempt organization must allocate deductions on a reasonable basis
between separate unrelated trades or businesses. The proposed
regulations also provide that the use of the unadjusted gross-to-gross
method is not a reasonable allocation method under the general
allocation rule and as incorporated for section 512(a)(6) purposes (see
section 1.d.iii of this preamble).
ii. State and Local Taxes and Tax Preparation Fees
At least one commenter requested guidance on the deduction of
certain general expenses. This commenter recommended that tax return
preparation fees be permitted as a deduction after calculation of total
UBTI under section 512(a)(6)(B). The commenter argued that such
expenses should not be allocated between separate unrelated trades or
businesses because such expenses pertain to all the exempt
organization's activities--related and unrelated.
As previously discussed, deductions are permitted under section
512(a)(1) and (3) only if two conditions are met: (1) The deduction is
allowed under chapter 1; and (2) in the case of section 512(a)(1), the
deduction is directly connected with the carrying on of such separate
unrelated trade or business, or, in the case of section 512(a)(3), the
deduction is directly connected with the production of the gross income
(excluding exempt function income). Accordingly, an exempt organization
may deduct only tax return preparation fees that are directly connected
with a separate unrelated trade or business, in the case of an
organization subject to section 512(a)(1), or that are directly
connected with the production of the gross income (excluding exempt
function income), in the case of an organization subject to section
512(a)(3). If such fees are directly connected with more than one
separate unrelated trade or business or are also attributable to the
exempt organization's related activities (or exempt function income in
the case of an organization subject to section
[[Page 23178]]
512(a)(3)), the exempt organization must allocate such expenses as
discussed in section 4.d.i of this preamble. See Sec. 1.512(a)-1(c).
Nothing in section 512(a)(6)(B) permits either the deduction of
expenses that are not otherwise deductible in calculating UBTI or the
deduction of expenses after calculation of total UBTI. Thus, the
Treasury Department and the IRS do not adopt this comment.
One commenter also suggested that state income taxes not directly
connected with any separate unrelated trade or business resulting from
the increase in UBTI under section 512(a)(7) be permitted as a
deduction after calculation of total UBTI under section 512(a)(6)(B).
With the repeal of section 512(a)(7), the Treasury Department and the
IRS expect that exempt organizations are no longer subject to state
income taxes that are not directly connected with the carrying on of a
separate unrelated trade or business. If this is not the case, the
Treasury Department and the IRS request examples of such state income
taxes.
iii. The Unadjusted Gross-to-Gross Method Is Unreasonable
The IRS has previously indicated that it will not litigate the
reasonableness of the allocation method in Rensselaer pending revision
of the Treasury regulations. 732 F.2d 1058, action on dec., 1987-014
(Jun. 18, 1987). However, regarding facilities or personnel that are
used both to carry on exempt activities and to conduct unrelated trade
or business activities or more than one separate unrelated trade or
business, the Treasury Department and the IRS have concluded that
allocation of expenses, depreciation, and similar items using an
unadjusted gross-to-gross method is not reasonable. In general, a
gross-to-gross method of allocation uses a ratio of gross income from
an unrelated trade or business activity over the total gross income
from both unrelated and related activities generating the same indirect
expenditures. The percentage resulting from this ratio is used to
determine the percentage of the shared costs attributable to the
unrelated trade or business activity (or activities).
In some circumstances, the provision of a good or service can be
both related and unrelated depending on to whom the good or service is
offered. For example, with respect to social clubs, the provision of
goods and services to members is an exempt function whereas the
provision of the same goods and services to nonmembers is a nonexempt
function. Another example is a school that operates a ski facility for
use in its physical education program and for recreational use by its
students and the general public. Rev. Rul. 78-98, 1978-1 C.B. 167. If
the social club charges nonmembers a higher price than it charges
members for the same good or service or if the school charges the
general public more for slope and ski lift fees than it charges its
students, the gross-to-gross ratio will increase, resulting in more
indirect expenses being allocated to the unrelated activity. However,
no difference likely exists in the cost of providing the good or
service to members versus nonmembers or in the cost of providing the
ski slopes and lifts to students versus the public. Accordingly, the
failure to adjust the price of the good or service offered to
nonmembers or the general public for purposes of determining the
allocation of indirect expenses (that is, using an unadjusted gross-to-
gross method) overstates the percentage of the indirect expenses that
should be allocated to the unrelated activities. See Portland Golf, 497
U.S. at 157 fn. 4 (indicating that a system where the taxpayer
``charges nonmembers higher prices for food and drink than members are
charged, even though nonmembers' meals presumably cost no more to
prepare and serve'' seems likely to ``[overstate] the percentage of
fixed costs properly attributable to nonmember sales'').
When an organization charges different prices for the same good or
service depending on whether the offering of the good or service is a
related or unrelated activity, then such organization should adjust the
per ``unit'' price of the good or service of the related activity to
that of the unrelated activity (or activities) for the ratio created by
the gross-to-gross method to appropriately account for the percentage
of indirect expenses attributable to the unrelated activity. Failing to
make this adjustment does not appropriately account for the portion of
indirect expenses attributable to an unrelated activity and is
therefore an unreasonable method for allocating expenditures under
Sec. 1.512(a)-1(c). Accordingly, the proposed regulations provide that
the unadjusted gross-to-gross method is not reasonable, whether under
the general allocation rule or as incorporated for section 512(a)(6)
purposes.
The Treasury Department and the IRS request comments regarding
whether any other allocation methods should be considered unreasonable
and the methods or rules that could be adopted instead of a
reasonableness standard for allocations both between related and
unrelated activities and between two or more separate unrelated trades
or businesses.
2. Activities in the Nature of Investments
Several commenters expressed concern regarding the use of the NAICS
codes to identify investment activities as one or more separate
unrelated trades or businesses. One commenter noted that a partnership
is not required to report the NAICS codes for all the trades or
businesses in which it engages on the Schedule K-1 (Form 1065),
``Partner's Share of Income, Deductions, Credits, etc.,'' provided to
its partners. Another commenter expressed concern that the NAICS codes
lacked specificity for purposes of sufficiently identifying an exempt
organization's investment activities. Therefore, two commenters
suggested that an exempt organization's investment activities be
identified separately from other activities identified using the NAICS
codes.
Consistent with Notice 2018-67, the proposed regulations generally
permit the aggregation of the investment activities specifically listed
in the proposed regulations for purposes of section 512(a)(6) to
mitigate the burden on exempt organizations, particularly those with
interests in multi-tier partnerships. However, under the proposed
regulations, investment activities are not identified using NAICS 2-
digit codes. Specifically, the proposed regulations provide that NAICS
2-digit codes are used to identify separate unrelated trades or
businesses except to the extent provided in other paragraphs of the
proposed regulations. Under the proposed regulations, an exempt
organization's investment activities, as well as the separate unrelated
trades or businesses discussed in sections 3 and 4 of this preamble,
are identified as described in the proposed regulations and reported as
described in the forms and instructions (see section 8 of this
preamble).
a. Investment Activities Are Treated as a Separate Unrelated Trade or
Business for Purposes of Section 512(a)(6)
As a general matter, a number of commenters suggested that the
Treasury Department and the IRS should not treat an exempt
organization's investment activities as an unrelated trade or business,
and therefore the income and losses from these activities should not be
considered for purposes of applying section 512(a)(6). The Treasury
Department and the IRS have concluded that the structure and purposes
of sections 511 through 514 indicate that an exempt organization's
investment activities should be treated as a separate unrelated trade
or business for purposes of section 512(a)(6). Section 512(a)(1)
[[Page 23179]]
provides that UBTI means the gross income derived by an exempt
organization from any unrelated trade or business regularly carried on
by it. Further, section 512(a)(1) provides that an exempt organization
excludes from the calculation of UBTI the amounts described in section
512(b)(1), (2), (3), and (5)--that is, dividends, interest, annuities,
etc.; royalties; rents; and capital gains. If an exempt organization's
investment activities were not an unrelated trade or business,
exclusion of certain amounts under section 512(b), such as capital
gains (and losses) under section 512(b)(5), would appear to be
unnecessary. Furthermore, other income that an exempt organization may
consider ``investment income''--such as unrelated debt-financed
income--is treated as ``derived from an unrelated trade or business''
under other paragraphs of section 512(b)--including section 512(b)(4).
The application of section 512(a)(6) to income included in UBTI under
section 512(b)(4), (13), or (17) is discussed in more detail in section
3 of this preamble.
Some commenters cited Higgins v. Commissioner, 312 U.S. 212 (1941),
to support the position that an exempt organization's investment of its
own assets is not a trade or business. However, Higgins is not relevant
under sections 511 through 514 because it applies to individuals, not
corporations or trusts. For the taxable years involved in Higgins, a
deduction was allowed for all ordinary and necessary expenses of
carrying on a trade or business, but a deduction was not allowed for
personal, living, or family expenses. Congress responded to Higgins by
enacting what is now section 212(1) to allow individuals to deduct all
ordinary and necessary expenses incurred in the production or
collection of income. Estate of Rockefeller v. Commissioner, 762 F.2d
264, 266 n.3 (2d Cir. 1985). Section 212 applies only to individuals.
Corporations or trusts may deduct only ``ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any
trade or business'' under section 162. Thus, no deduction for expenses
directly connected with investment activities would be permitted to a
corporation or trust unless its investment activities are a part of a
trade or business within the meaning of section 162.
However, the Treasury Department and the IRS recognize that exempt
organizations have UBTI under sections 511 through 514 from activities
engaged in with an intent to make an investment rather than with the
intent to actively participate in any of the unrelated trade or
business activities generating the UBTI. Accordingly, Notice 2018-67
stated that, as a matter of administrative convenience, the proposed
regulations would treat an exempt organization's investment activities
as one trade or business for purposes of section 512(a)(6)(A) in order
to permit the exempt organization to aggregate gross income and
directly connected deductions from possibly multiple separate unrelated
trades or businesses. After publication of Notice 2018-67, the Joint
Committee on Taxation (JCT) confirmed that ``it is intended that the
Secretary consider whether it would be appropriate in certain cases to
permit an organization that maintains an investment portfolio to treat
multiple investment activities as one unrelated trade or business.''
Staff of the Joint Committee on Taxation, General Explanation of Public
Law 115-97 (December 2018), at 293 (General Explanation). Consistent
with Notice 2018-67 and the General Explanation, the proposed
regulations provide that an exempt organization's various investment
activities, as exclusively listed therein, are treated as a separate
unrelated trade or business for purposes of section 512(a)(6)(A) and
the proposed regulations.
b. Exclusive List of ``Investment Activities''
Notice 2018-67 did not define the term ``investment activities''
but rather requested comments regarding the scope of the activities,
both investment partnership interests or other investment activities,
that should be included in the category of ``investment activities''
for purposes of section 512(a)(6). Some commenters suggested that the
term ``investment activities'' include all passive income. Some of
these commenters specifically suggested using the definition of
``material participation'' in section 469 as a method to identify
``investment activities.'' However, most commenters addressing this
issue suggested that the term ``investment activities'' should include
activities that give rise to amounts included as: An item of gross
income derived from an unrelated trade or business under section
512(b)(4) (debt-financed property), (13) (certain amounts received from
controlled entities), and (17) (certain amounts derived from foreign
corporations); gross income (or loss) from a partnership that is not
directly or indirectly controlled by the exempt organization; and, with
respect to controlled partnerships, an item of gross income derived
from an unrelated trade or business under section 512(b)(4), (13), and
(17).
In drafting these proposed regulations, the Treasury Department and
the IRS considered whether to provide a general definition of the term
``investment activities.'' However, even though other areas of the Code
make a distinction between ``active'' and ``passive'' activities, those
distinctions are not applicable for purposes of sections 511 through
514. Section 512(c) applies regardless of whether the exempt
organization is an active or passive participant in the unrelated trade
or business of the partnership or whether it is a general or limited
partner. Rev. Rul. 79-222; Service Bolt & Nut Co. v. Commissioner, 724
F.2d 519, 523-24 (6th Cir., 1983), affg, 78 T.C. 812 (1982); see also
Leila G. Newhall Unitrust v. Commissioner, 105 F.3d 482 (9th Cir.
1997), affg, 104 T.C. 236 (1995) (following Service Bolt & Nut, 724
F.2d 519). Thus, the Treasury Department and the IRS do not believe
that use of the criteria for finding ``material participation'' under
section 469 is appropriate in applying section 512(a)(6).
Rather, the proposed regulations provide an exclusive list of an
exempt organization's investment activities that can be treated as one
separate unrelated trade or business for purposes of section 512(a)(6).
Under the proposed regulations, for most exempt organizations, such
investment activities are limited to: (i) Qualifying partnership
interests (see section 2.d of this preamble); (ii) debt-financed
properties (see section 3.a of this preamble); and (iii) qualifying S
corporation interests (see section 4.a of this preamble). As discussed
in section 5.b.i of this preamble, the qualifying partnership rules do
not apply to social clubs described in section 501(c)(7). However, for
exempt organizations subject to section 512(a)(3) (including social
clubs), the proposed regulations clarify that UBTI from the investment
activities of such organizations includes certain additional amounts
(see section 5.a of this preamble).
The Treasury Department and the IRS will continue to consider
whether the term ``investment activities'' can be defined more
generally in a manner that is administrable and consistent with the
legislative intent of section 512(a)(6). The Treasury Department and
the IRS request comments regarding the specific factors that should be
considered when determining whether an activity is an investment
activity for purposes of section 512(a)(6).
[[Page 23180]]
c. Partnership Interests
With respect to partnership interests, the Treasury Department and
the IRS stated in Notice 2018-67 that the category of ``investment
activities'' for purposes of section 512(a)(6) should include only
partnership interests in which the exempt organization does not
significantly participate in any partnership trade or business. Some
commenters suggested including in this category partnerships over which
the exempt organization has no control, which is discussed in more
detail in section 2.d of this preamble.
Other commenters suggested that this category include all limited
partnerships or limited liability companies (LLCs) in which the exempt
organization is a non-managing member (regardless of the exempt
organization's percentage interest or other participation in the
partnership). The Treasury Department and the IRS decline to adopt this
comment because of the variation in state law for determining non-
managing member equivalent interests and the administrative burden that
reliance on state law places on the IRS. Nonetheless, as discussed in
section 2.d.iii.B of this preamble, the Treasury Department and the IRS
recognize that there may be rights or actions permitted by state law
that are normal and routine and that do not indicate any measurable
influence or control over a partnership. Accordingly, the Treasury
Department and the IRS request comments on whether certain permitted
rights or actions should be disregarded in determining whether a
partnership interest is a qualifying partnership interest. In addition,
the proposed regulations clarify that any partnership in which an
exempt organization is a general partner for any federal tax purpose is
not a qualifying partnership interest within the meaning of the
proposed regulations, regardless of the exempt organization's
percentage interest.
d. Qualifying Partnership Interests
Pending publication of proposed regulations, the interim rule
described in Notice 2018-67 permitted an exempt organization to
aggregate its UBTI from certain partnership interests with multiple
trades or businesses, including trades or businesses conducted by
lower-tier partnerships (qualifying partnership interest). See section
6.01(2) of Notice 2018-67. Additionally, the interim rule permitted the
aggregation of any qualifying partnership interest (QPI) with all other
QPIs, resulting in the treatment of the aggregate group of QPIs as a
single trade or business for purposes of section 512(a)(6)(A). Id.
Although some commenters suggested retaining the interim rule as
described in Notice 2018-67, the majority of commenters appeared to
support retention of the interim rule but made suggestions regarding
possible revisions that potentially could reduce any administrative
burden associated with the rule. Consistent with these comments, the
proposed regulations retain the interim rule with the modifications
described in the following sections of this preamble.
i. Designation of a QPI
Like Notice 2018-67, the proposed regulations permit, but do not
require, an organization to aggregate its UBTI from QPIs. See section
6.01(2) of Notice 2018-67. However, the proposed regulations add that,
once an organization designates a partnership interest as a QPI (in
accordance with forms and instructions), it cannot thereafter identify
the trades or businesses conducted by the partnership that are
unrelated trades or businesses with respect to the organization using
NAICS 2-digit codes unless and until the partnership interest is no
longer a QPI. For example, if an organization has a partnership
interest that is a QPI and the organization designates that partnership
interest as a QPI on its Form 990-T, the organization cannot, in the
next taxable year, identify the trades or businesses of the partnership
that are unrelated trades or businesses with respect to the
organization using NAICS 2-digit codes. However, if in a future taxable
year, the organization's partnership interest is no longer a QPI, then
the organization would be required to identify the trades or business
of the partnership that are unrelated trades or businesses with respect
to the organization using NAICS 2-digit codes.
A partnership interest is a QPI if it meets the requirements of
either the de minimis test (discussed in section 2.d.ii of this
preamble) or the control test (discussed in section 2.d.iii of this
preamble).
ii. The De Minimis Test
Both Notice 2018-67 and the proposed regulations provide that a
partnership interest is a QPI that meets the requirements of the de
minimis test if the exempt organization holds directly no more than 2
percent of the profits interest and no more than 2 percent of the
capital interest. See section 6.02(1) of Notice 2018-67. As noted by
several commenters, the 2 percent threshold for the de minimis test is
consistent with the de minimis test under section 4943, which provides
that a private foundation does not have excess business holdings in any
corporation in which it (together with certain related private
foundations described in section 4946(a)(1)(H)) owns not more than 2
percent of the voting stock and not more than 2 percent in value of all
outstanding shares of all classes of stock. The Treasury Department and
the IRS chose not to cross-reference the section 4943 de minimis test
because that section applies only to private foundations. Nonetheless,
because Congress adopted a 2 percent de minimis test under section
4943, the Treasury Department and the IRS consider a 2 percent
threshold to be appropriate for purposes of the de minimis test in the
proposed regulations.
However, the proposed regulations make two changes to the de
minimis test provided in Notice 2018-67 to improve administrability and
to provide more appropriate relief. First, as discussed in section
2.d.iv of this preamble, an exempt organization is no longer required
to combine certain related interests when determining whether a
partnership interest meets the requirements of the de minimis test.
Second, in response to comments that the interim rule should apply to
lower-tier partnerships, the proposed regulations provide that, if an
exempt organization does not control a partnership in which the exempt
organization holds a direct interest (directly-held partnership
interest) but that directly-held partnership interest is not a QPI
because the exempt organization holds more than 20 percent of the
capital interest, any partnership in which the exempt organization
holds an indirect interest through the directly-held partnership
interest (indirectly-held partnership interest) may be a QPI if the
indirectly-held partnership interest meets the requirements of the de
minimis test (look-through rule). Accordingly, the proposed regulations
permit (but do not require) an exempt organization to aggregate the
UBTI from some indirectly-held QPIs with its directly-held QPIs.
However, the look-through rule does not apply to indirectly-held QPIs
that do not meet the requirements of the de minimis test but may meet
the requirements of the control test.
For example, if an exempt organization directly holds 50 percent of
the capital interests of a partnership that it does not control and the
directly-held partnership holds 4 percent of the capital and profits
interests of lower-tier partnership A and 10 percent of the
[[Page 23181]]
capital and profits interests of lower-tier partnership B, the exempt
organization can aggregate its interest in lower-tier partnership A
with its other QPIs because the exempt organization indirectly holds 2
percent of the capital and profits interests of lower-tier partnership
A (4 percent x 50 percent = 2 percent). However, the exempt
organization may not aggregate its interest in lower-tier partnership B
with its QPIs because the exempt organization indirectly holds 5
percent (10 percent x 50 percent) of the capital and profits interest
of lower-tier partnership B, which does not meet the requirements of
the de minimis test.
If a directly-held partnership interest is not a QPI, the general
principles of section 512(c) apply and the exempt organization is
required to identify the trades or businesses conducted by the
directly-held partnership, and any indirectly-held partnerships, that
are unrelated trades or businesses with respect to the exempt
organization. The Treasury Department and the IRS expect that
permitting an exempt organization to aggregate any indirectly-held
partnership interests that meet the requirements of the de minimis test
with all other QPIs will reduce the administrative burden on exempt
organizations because there will be no need to identify each trade or
business conducted by such indirectly-held partnership. However, the
Treasury Department and the IRS request comments regarding the
administrability of permitting the aggregation of indirectly-held
partnership interests that meet the requirements of the de minimis
test.
iii. The Control Test
Notice 2018-67 stated that a partnership interest is a QPI that
meets the requirements of the control test if the exempt organization
(i) directly holds no more than 20 percent of the capital interest; and
(ii) does not have control or influence over the partnership. See
section 6.03(1) of Notice 2018-67.
A. Percentage Interest
Numerous commenters made recommendations regarding the first prong
of the control test, most of which recommend increasing the percentage
threshold to 50 percent to conform with the definition of control in
section 512(b)(13). Multiple commenters suggested that the percentage
control requirement be eliminated entirely.
The proposed regulations retain the 20 percent threshold used in
Notice 2018-67. The Treasury Department and the IRS intend the
percentage threshold to be a proxy to identify partnership interests in
which the exempt organization does not significantly participate in any
partnership trade or business and therefore may appropriately be
considered an investment activity for purposes of section 512(a)(6).
The 20 percent threshold is consistent with at least one other
administrative exception created for certain investment activities. See
section 731(c)(3)(C)(i) & Sec. 1.731-2(e). Accordingly, the proposed
regulations treat a 20 percent interest in a partnership over which the
exempt organization partner has no control (see section 2.d.iii.B of
this preamble) as a part of the exempt organization's investment
activities. However, as with the de minimis test, an exempt
organization is no longer required to combine certain related interests
when determining whether a partnership interest meets the 20 percent
threshold under the control test (see section 2.d.iv of this preamble).
The Treasury Department and the IRS recognize that an exempt
organization may have more than 20 percent of the capital interests of
a partnership but the exempt organization may consider that partnership
interest to be part of its investment activities raising funds for its
exempt activities. However, as discussed in section 2.b of this
preamble, the proposed regulations do not provide a general definition
of the term ``investment activities'' such that a non-QPI could be
aggregated with the exempt organization's other investment activities
for purposes of section 512(a)(6). While the addition of the look-
through rule to the de minimis test in these proposed regulations may
result in the aggregation of some of the lower-tier partnership
interests of a directly-held non-QPI, an exempt organization's
investment intent is not sufficient to treat the overall non-QPI as
part of its investment activities.
At least two commenters suggested that the capital interests in a
partnership do not indicate control over a partnership. The Treasury
Department and the IRS understand that a partner's percentage interest
in the capital interests of a partnership does not necessarily
correlate with the partner's ability to control the partnership.
However, the Treasury Department and the IRS have concluded that a
combination of an exempt organization's percentage capital interest in
a partnership and the exempt organization's ability to control the
partnership are an appropriate administrative proxy for determining
whether a partnership interest is an investment activity. The use of a
percentage interest, in addition to the definition of ``control''
discussed in section 2.d.iii.B of this preamble, provides a bright line
for the evaluation of partnership interests that may be investment
activities. Furthermore, because an exempt organization's percentage
profits interest may change throughout the year, the proposed
regulations continue to consider only an exempt organization's capital
interest in a partnership for purposes of the control test.
B. Definition of ``Control''
Notice 2018-67 provided that all facts and circumstances are
relevant for determining whether an exempt organization has control or
influence over a partnership. See section 6.03(3) of Notice 2018-67.
Notice 2018-67 then provided three specific circumstances in which an
exempt organization has control or influence. Id. Commenters generally
appeared to support the inclusion of a facts and circumstances test.
Nonetheless, numerous commenters suggested revisions to what it means
for an exempt organization to have influence or control over a
partnership.
First, Notice 2018-67 provided that an exempt organization has
control or influence if the exempt organization may require the
partnership to perform, or may prevent the partnership from performing,
any act that significantly affects the operations of the partnership.
Several commenters recommended that the proposed regulations clarify
that the right to vote for the appointment or removal of a general
partner or managing member, the ability to appoint representatives to
investor committees or advisory committees, and the right to approve
the selection or removal of a general partner or managing member do not
evidence influence or control. These commenters explained that these
rights help ensure that the general partner cannot alter a partnership
without the consent of the limited partners. Similarly, other
commenters requested that the proposed regulations clarify that an
exempt organization will not be deemed to have influence or control
over a partnership if it exercises its rights or takes actions that it
is permitted to take under state law while maintaining its limited
liability status in a partnership.
Second, Notice 2018-67 provided that an exempt organization has
control or influence over a partnership if any of the exempt
organization's officers, directors, trustees, or employees have rights
to participate in the management of the partnership or conduct the
partnership's business at any time, or if
[[Page 23182]]
the exempt organization has the power to appoint or remove any of the
partnership's officers, directors, trustees, or employees. One
commenter stated that the presence of these rights or powers does not
necessarily illustrate control. Another commenter suggested that this
rule is overly restrictive and will cause many partnership interests in
which an exempt organization has no influence or control to fail to
meet the requirements of the control test. This commenter stated that
many exempt organizations have governing board members that also work
in the investment management industry and may participate in conducting
the business of a partnership in which the exempt organization invests.
The commenter explained that these individuals' expertise in financial
management is essential for the prudent management of an exempt
organization's investments. The commenter argued that a general rule
based on facts and circumstances is sufficient to address situations in
which an exempt organization exercises ``excessive'' influence or
control over a partnership such that it should not be considered a QPI.
The proposed regulations retain the control rule described in
Notice 2018-67 with minor modifications to address the comments
described above. In particular, the proposed regulations remove the
term ``influence'' so that the second prong of the control test
provides that, if the exempt organization has 20 percent or less of the
capital interests, a partnership interest is a QPI that meets the
requirements of the control test if the exempt organization does not
control the partnership. Consistent with Notice 2018-67, the proposed
regulations provide that all the facts and circumstances are relevant
for determining whether an exempt organization controls a partnership.
The proposed regulations clarify that the partnership agreement is
among the facts and circumstances that may be considered when making a
determination of control.
The proposed regulations also list certain specific circumstances
that evidence control, focusing on four discrete rights or powers. Two
circumstances focus on the exempt organization's ability to perform
certain actions on its own. Specifically, the proposed regulations
provide that an exempt organization controls a partnership if the
exempt organization, by itself, may require the partnership to perform,
or may prevent the partnership from performing, any act that
significantly affects the operations of the partnership or has the
power to appoint or remove any of the partnership's officers or
employees or a majority of directors. The remaining two circumstances
focus on whether any of the exempt organization's officers, directors,
trustees, or employees have rights to participate in the management of
the partnership at any time or to conduct the partnership's business at
any time. No exception is provided for certain professionals that may
serve on the boards of both the exempt organization and partnerships in
which the exempt organization is a partner.
The Treasury Department and the IRS recognize that, although these
rights or powers indicate control in some situations, other facts and
circumstances may tip the scale the other way. Accordingly, the
Treasury Department and the IRS request comments regarding whether all
these rights or powers should be weighted the same or whether there are
certain circumstances in which such right or power would never indicate
control.
iv. Combining Related Interests
Both the de minimis test and the control test in Notice 2018-67
required an exempt organization to own less than a certain percentage
of the profits and capital interests in a partnership. See sections
6.02(1) (de minimis test) and 6.03(1) (control test) of Notice 2018-67.
In determining the exempt organization's ownership percentage, both the
de minimis test and the control test required the exempt organization
to combine certain related interests (aggregation rule). Id. The
aggregation rule in section 6.02(2)(b)(i) of Notice 2018-67 provided
that, when determining an exempt organization's percentage partnership
interest, the interest of a disqualified person (as defined in section
4958(f)), a supporting organization (as defined in section 509(a)(3)),
or a controlled entity (as defined in section 512(b)(13)) in the same
partnership would be taken into account. See section 6.02(2)(b)(ii)
through (iv) of Notice 2018-67.
Most commenters suggested that the aggregation rule is overly
burdensome and requested that it be removed. Commenters noted that many
public charity boards have numerous members and argued that verifying
the board members' ownership percentages, after taking into account
other related interests, for every partnership interest that generates
UBTI would be unreasonable, if not impossible. Additionally, these
commenters stated that the exempt organization cannot usually obtain
information about other partners from the partnerships in which it
holds interests because of confidentiality agreements.
If the aggregation rule is retained, commenters recommended several
revisions. First, two commenters suggested eliminating the aggregation
rule for the de minimis test. Next, a commenter suggested only
requiring aggregation of interests owned by controlled entities and
persons with direct control over the exempt organization's investment
decisions. Additionally, another commenter would limit aggregation with
interests owned by controlled entities to those interests owned by Type
I and II supporting organizations described in section 509(a)(3)(B)(i)
and (ii) and exclude interests owned by Type III supporting
organizations described in section 509(a)(3)(B)(iii). Finally, another
commenter suggested requiring aggregation with interests owned by
controlled entities but not interests owned by persons or organizations
that are not controlled by the exempt organization.
The proposed regulations retain a modified aggregation rule to
address situations in which an exempt organization may control a
partnership through the aggregation of interests. The aggregation rule
in the proposed regulations differs from the aggregation rule in Notice
2018-67 in two ways. First, the aggregation rule in the proposed
regulations applies only for purposes of the control test and not for
purposes of the de minimis test. Second, the proposed regulations do
not require an exempt organization to take into account the interests
of disqualified persons when determining the exempt organization's
percentage interest in a partnership for purposes of the control test.
The proposed regulations adopt other aspects of the aggregation
rule from Notice 2018-67 without change. In particular, the proposed
regulations include the definitions of ``supporting organization'' and
``controlled entity'' used in Notice 2018-67, which cross-referenced
sections 509(a)(3) and 512(b)(13)(D), respectively. Additionally, the
proposed regulations provide that, when determining an exempt
organization's percentage interest in a partnership for purposes of the
control test, the interests of a supporting organization or a
controlled entity in the same partnership will be taken into account.
However, the Treasury Department and the IRS will continue to consider
whether the aggregation of the interests of supporting organizations is
appropriate in the circumstance in which the exempt organization is a
supported
[[Page 23183]]
organization that has little to no control over its supporting
organizations.
v. Reliance on Schedule K-1 (Form 1065)
Notice 2018-67 provided that, in determining the exempt
organization's percentage interest in a partnership, the exempt
organization may rely on the Schedule K-1 (Form 1065) (or its
successor) it receives from the partnership. Commenters requested
various revisions to the Schedule K-1 (Form 1065) to assist in the
reporting process. The Treasury Department and the IRS will consider
revisions to the Schedule K-1 (Form 1065). Otherwise, the proposed
regulations continue to permit reliance on Schedule K-1 (Form 1065) if
the form lists the exempt organization's percentage profits interest or
its percentage capital interest, or both, at the beginning and end of
the year. However, the proposed regulations clarify that the exempt
organization may not rely on the form to the extent that any
information about the exempt organization's percentage interest is not
specifically provided. For example, if the Schedule K-1 (Form 1065) an
exempt organization receives from a partnership lists the exempt
organization's percentage capital interest at the beginning and end of
the year but lists its profits interest as ``variable,'' the exempt
organization may rely on the form only with respect to its percentage
capital interest.
vi. Additional Recommended Changes
Commenters suggested additional modifications to the de minimis and
control tests, including phase-in and grace periods to address changes
in an exempt organization's percentage interest that are beyond the
exempt organization's control. Two commenters requested that an exempt
organization be permitted up to 90 days to reduce its interest in a
partnership in order to satisfy the requirements of the de minimis test
if the increase in interest was because of another partner's withdrawal
or percentage reduction. Another commenter suggested that, if a
partnership interest met the requirements of either the de minimis test
or the control test in a taxable year, the partnership interest should
continue to meet those requirements in the following taxable years if
the exempt organization's percentage interest changed through no action
of the exempt organization partner.
The proposed regulations do not adopt any of these recommended
changes because the de minimis and control tests are rules of
administrative convenience. Allowing greater interests due to other
actions would require other safeguards and limitations that would
complicate the rule and place additional administrative burdens on
exempt organizations and the IRS. Nevertheless, the Treasury Department
and the IRS recognize that an exempt organization may not be aware of
changes in its partnership interest until it receives a Schedule K-1
(Form 1065) from the partnership at the end of the partnership's
taxable year. In such a circumstance, it may be appropriate to permit a
higher percentage interest in taxable years in which the increase in an
exempt organization's percentage interest during a taxable year is the
result of the actions of other partners. Accordingly, the Treasury
Department and the IRS request comments regarding whether permitting a
higher percentage interest in taxable years in which the increase
occurs as the result of the actions of other partners would address
these commenters' concerns.
e. Transition Rule
Pending publication of proposed regulations, the transition rule in
Notice 2018-67 permitted an exempt organization to treat each
partnership interest acquired prior to August 21, 2018, that failed to
meet the requirements of either the de minimis test or the control test
as one trade or business for purposes of section 512(a)(6), regardless
of whether there was more than one trade or business directly or
indirectly conducted by the partnership or lower-tier partnerships. See
section 6.04 of Notice 2018-67.
Many commenters asserted that the transition rule should apply to
any partnership interest held by an exempt organization regardless of
the date acquired. However, in the case of a partnership that conducts
more than one trade or business that is a separate unrelated trade or
business with respect to the exempt organization, applying the
transition rule to all partnership interests and treating each non-QPI
as one trade or business would undermine the purpose of section
512(a)(6) by allowing the gains from one unrelated trade or business to
offset the losses from another unrelated trade or business.
Accordingly, the Treasury Department and the IRS do not accept this
comment.
Other commenters suggested that the proposed regulations should
clarify that, if an exempt organization acquired a partnership interest
before August 21, 2018, changes in the exempt organization's percentage
interest would not affect the availability of the transition rule.
Accordingly, the proposed regulations clarify that a partnership
interest acquired prior to August 21, 2018, will continue to meet the
requirement of the transition rule even if the exempt organization's
percentage interest changes on or after August 21, 2018.
The proposed regulations also include two additions to the
transition rule. First, the proposed regulations permit an exempt
organization to rely on the transition rule only until the first day of
the organization's first taxable year beginning after the date these
proposed regulations are published as final regulations (transition
period). Second, the proposed regulations provide that an exempt
organization may apply either the transition rule or the look-through
rule, but not both, to a partnership interest that meets the
requirements for both rules. During the transition period, the exempt
organization must determine how a partnership interest to which it
chose to apply the transition rule will be treated under the final
regulations. The Treasury Department and the IRS request comments
regarding whether any additional transitional relief is necessary.
3. Inclusions of Income Derived From an Unrelated Trade or Business
Under Section 512(b)(4), (13), and (17)
Section 512(b)(4), (13), and (17) require the inclusion of certain
income as items of gross income derived from an unrelated trade or
business if such income is unrelated debt-financed income, a specified
payment from controlled entities, or certain insurance income derived
from a controlled foreign corporation, respectively. In Notice 2018-67,
the Treasury Department and the IRS explained that, in the absence of
section 512(b)(1), (2), (3), and (5), the income described in these
sections would be included in the calculation of UBTI to the extent
that such amounts are ``gross income derived by any organization from
any unrelated trade or business . . . regularly carried on by it''
under section 512(a)(1). Accordingly, the Treasury Department and the
IRS stated that no distinction existed between ``gross income derived
by any organization from any unrelated trade or business . . .
regularly carried on by it'' within the meaning of section 512(a)(1)
and amounts included ``as an item of gross income derived from an
unrelated trade or business'' under section 512(b)(4), (13), and (17).
However, the Treasury Department and the IRS recognized that some
interpretations of section 512(a)(6) might impose a significant burden
on exempt organizations required to include certain income in UBTI
under section 512(b)(4), (13), or (17), and,
[[Page 23184]]
consequently, that aggregating income included in UBTI under these
sections may be appropriate in certain circumstances. In Notice 2018-
67, the Treasury Department and the IRS requested comments regarding
the treatment under section 512(a)(6) of income that is not from a
partnership, but that is included in UBTI under section 512(b)(4),
(13), and (17).
A few commenters disagreed with the statement that there is ``no
distinction between `gross income derived by any organization from any
unrelated trade or business . . . regularly carried on by it' under
section 512(a)(1) and amounts included in UBTI `as an item of gross
income derived from an unrelated trade or business' under section
512(b)(4), (13), and (17).'' These commenters argued that amounts
included as items of gross income from an unrelated trade or business
under section 512(b)(4), (13), and (17) should not be subject to
section 512(a)(6) because such amounts are treated as income from
investment activities and not as gross income from a trade or business.
As discussed in section 2.a of this preamble, investment activities
are treated as a separate unrelated trade or business for purposes of
section 512(a)(6). Furthermore, section 512(b)(4), (13), and (17) each
provide that income described in the provision is income derived from
an unrelated trade or business. Accordingly, amounts included in UBTI
under section 512(b)(4), (13), and (17) contribute to the determination
of whether an organization has more than one unrelated trade or
business and thus is subject to section 512(a)(6). After considering
the comments received and the legislative history of each section, the
Treasury Department and the IRS propose the following treatment of
amounts included in UBTI under section 512(b)(4), (13), and (17) for
purposes of section 512(a)(6).
a. Unrelated Debt-Financed Income
In the case of debt-financed property (as defined in section 514),
section 512(b)(4) requires an exempt organization to include, as an
item of gross income from an unrelated trade or business, any unrelated
debt-financed income, determined under section 514, with respect to
such debt-financed property, even if an amount received with respect to
the debt-financed property would ordinarily be excluded from the
calculation of UBTI under section 512(b)(1), (2), (3), or (5). Section
514(b)(1) defines the term ``debt-financed property'' as any property
that is held to produce income and with respect to which there is
acquisition indebtedness. Section 1.514(b)-1(a) clarifies that property
held to produce income includes rental real estate, tangible personal
property, and corporate stock. Section 1.514(a)-1(a) provides that the
calculation of debt-financed taxable income is made on a property-by-
property basis. Thus, as stated in Notice 2018-67, one interpretation
of sections 512(b)(4) and 514 and the regulations thereunder could
require each debt-financed property to be treated as a separate
unrelated trade or business under section 512(a)(6).
However, the amounts excluded from the calculation of UBTI under
section 512(b)(1), (2), (3), and (5) that are included in UBTI if
subject to acquisition indebtedness include dividends, interest,
annuities, royalties, rents, and capital gains. As acknowledged in
section 2.a of this preamble, dividends, interest, annuities,
royalties, rents, and capital gains generally are income from
investment activities. Additionally, section 514 generally does not
apply to any property to the extent that the income from such property
is taken into account in computing the gross income of any unrelated
trade or business (except in the case of capital gains from such
property that would be excluded under section 512(b)(5)). See section
514(b)(1)(B). Accordingly, the Treasury Department and the IRS agree
with commenters that debt-financed properties (as defined in section
514) generally are held for investment purposes. Therefore, to reduce
the reporting burden on exempt organizations, the proposed regulations
include all the UBTI under section 512(b)(4) from an exempt
organization's debt-financed property or properties (and not just its
unrelated debt-financed income arising in connection with a QPI as
provided in Notice 2018-67) in the list of ``investment activities''
treated as a separate unrelated trade or business for purposes of
section 512(a)(6).
The Treasury Department and the IRS note that rental of certain
property is a trade or business that must be identified using NAICS 2-
digit codes. For example, section 512(b)(3)(B) provides that rents from
real and personal property are included in UBTI if more than 50 percent
of the total rent received or accrued under a lease is attributable to
personal property. Also, Sec. 1.512(b)-1(c)(5) indicates that payments
for the use or occupancy of rooms or other space where services are
also rendered to the occupant do not constitute rent from real
property. Sections 512(b)(4) and 514 do not apply where such real or
personal property is purchased with debt financing because the rents
from these properties will have already been included in UBTI. See
section 514(b)(1)(B) (providing that, except in the case of income
excluded under section 512(b)(5), the term ``debt-financed property''
does not include any property to the extent that the income from such
property is taken into account in computing the gross income of any
unrelated trade or business); Sec. 1.514(b)-1(b)(2)(i). Accordingly,
because rent from such real and personal property is included in UBTI,
the exempt organization must identify such unrelated trade or business
using the NAICS 2-digit code for real estate rental and leasing (53).
b. Specified Payments Received From Controlled Entities
Notwithstanding section 512(b)(1), (2), and (3), section
512(b)(13)(A) requires an exempt organization, referred to as a
``controlling organization,'' that receives or accrues (directly or
indirectly) a specified payment from another entity which it controls,
referred to as a ``controlled entity,'' to include such payment as an
item of gross income derived from an unrelated trade or business to the
extent such payment reduces the net unrelated income of the controlled
entity (or increases any net unrelated loss of the controlled entity).
See Sec. 1.512(b)-1(l)(1). Section 512(b)(13)(C) defines the term
``specified payment'' as any interest, annuity, royalty, or rent.
Accordingly, section 512(b)(13) treats certain amounts that would
ordinarily be excluded from the calculation of UBTI under section
512(b)(1), (2), and (3) as income derived from an unrelated trade or
business.
Commenters argued that amounts included in UBTI under section
512(b)(13) should be included with an exempt organization's other
investment activities. Presumably, this argument rests on the premise
that the types of payments described in section 512(b)(13)(C)--that is,
any interest, annuity, royalty, or rent--might be characterized
generally as ``investment income.'' However, treating specified
payments included in UBTI as income from an exempt organization's
investment activities would be inconsistent with the purpose of section
512(b)(13)(A), which is to prevent a controlled entity from gaining a
competitive advantage (in contravention of the purposes of section 512)
through making deductible payments to a controlling organization that
is exempt from tax. See S. Rep. No. 91-552, at 73 (1969) (explaining
that certain ``rental'' arrangements between exempt organizations and
taxable subsidiaries
[[Page 23185]]
``enable[ ] the taxable [subsidiary] to escape nearly all of its income
taxes''). Consistent with that purpose, section 512(b)(13)(A) treats a
specified payment as income from an unrelated trade or business only
``to the extent such payment reduces the net unrelated income of the
controlled entity (or increases any net unrelated loss of the
controlled entity).'' Section 512(b)(13) thus views such payments as
stemming from the trade or business activity of the controlled entity
rather than from the ``investment activity'' of the controlling
organization.
Further, the required degree of control of the controlling
organization over the controlled entity indicates that the controlled
entities are not a part of the controlling organization's otherwise
appropriately characterized investment activities. In general, section
512(b)(13)(D) defines the term ``control'' as ownership of more than 50
percent of the stock in a corporation, of the profits interests or
capital interests in a partnership, or, in any other case, of the
beneficial interests in an entity. The section 318 constructive
ownership rules apply when determining the ownership of stock in a
corporation, and similar principles apply in determining the ownership
of interests in other types of entities. As generally discussed in
section 2.d.iii.B of this preamble, control over an organization
suggests that such interest is not part of the exempt organization's
investment activities. Accordingly, even though the controlled entity's
trades or businesses might not be attributed to the controlling
organization (such as in the case of a controlled corporation), the
control itself indicates that the controlled entity is held as part of
a trade or business other than the controlling organization's
investment activities.
The plain language of section 512(b)(13) could require each
specified payment to be treated as a separate unrelated trade or
business under section 512(a)(6) because section 512(b)(13) requires an
exempt organization to include such payment as an item of gross income
derived from ``an'' unrelated trade or business. However, this
treatment may impose a considerable administrative burden on
controlling organizations that receive numerous specified payments from
controlled entities, such as may be the case with a university or
hospital system. Therefore, these proposed regulations permit an exempt
organization to aggregate all the specified payments received from a
controlled entity and to treat the payments as received from a single
separate unrelated trade or business for purposes of section 512(a)(6).
In particular, the proposed regulations provide that, if an exempt
organization controls another entity (within the meaning of section
512(b)(13)(D)), the specified payments from that controlled entity will
be treated as gross income from a separate unrelated trade or business
for purposes of section 512(a)(6). If a controlling organization
receives specified payments from two different controlled entities, the
payments from each controlled entity are treated as separate unrelated
trades or businesses. For example, a controlling organization that
receives rental payments from two controlled entities will have two
separate unrelated trades or businesses, one for each controlled
entity. The specified payments from a controlled entity will be treated
as gross income from one unrelated trade or business regardless of
whether the controlled entity engages in more than one unrelated trade
or business or whether the controlling organization receives more than
one type of specified payment from that controlled entity.
c. Certain Amounts Derived From Foreign Corporations
Section 512(b)(17) requires any amount included in gross income
under section 951(a)(1)(A) to be included as an item of gross income
derived from an unrelated trade or business to the extent the amount so
included is attributable to insurance income (as defined in section
953) which, if derived directly by the exempt organization, would be
treated as an unrelated trade or business. Section 953(a)(1) defines
``insurance income'' as any income that (A) is attributable to the
issuing (or reinsuring) of an insurance or annuity contract, and (B)
would (subject to certain modifications not relevant here) be taxed
under subchapter L of chapter 1 if such income were the income of a
domestic insurance company. Thus, section 512(b)(17) ``applies a look-
through rule in characterizing certain subpart F insurance income for
unrelated business income tax purposes.'' H.R. Rep. No. 104-586 (1996),
at 137.
Commenters have argued that insurance income included in UBTI under
section 512(b)(17) belongs in the category of investment activities.
However, like section 512(b)(13), the required degree of control of the
exempt organization over the controlled foreign corporation indicates
that the exempt organization's interest in a controlled foreign
corporation probably is not a part of the exempt organization's
otherwise appropriately characterized investment activities. In
particular, section 951(a)(1)(A) applies only if a foreign corporation
is a controlled foreign corporation, which section 957 defines as any
foreign corporation if more than 50 percent of the total combined
voting power of all classes of stock of such corporation entitled to
vote or the total value of the stock of such corporation is owned,
directly, indirectly, or constructively by United States shareholders.
Section 951(b) defines ``United States shareholder,'' with respect to
any foreign corporation, as a United States person (within the meaning
of section 7701(a)(30), which includes domestic corporations and
certain trusts) who owns, directly, indirectly, or constructively, 10
percent or more of the total combined voting power of all classes of
stock entitled to vote of such foreign corporation or 10 percent or
more of the total value of shares of all classes of stock of such
foreign corporation.
Furthermore, insurance income included in UBTI under section
512(b)(17) should not be treated as gross income from an exempt
organization's investment activities because the provision of insurance
generally is an unrelated trade or business. Section 501(m) provides
that, in the case of an exempt organization described in section
501(c)(3) or (4) that does not provide commercial-type insurance as a
substantial part of its activities, the activity of providing
commercial-type insurance is treated as an unrelated trade or business
(as defined in section 513). However, rather than treating insurance
income from each controlled foreign corporation as income from a
separate unrelated trade or business, these proposed regulations treat
the provision of insurance by all controlled foreign corporations as
one trade or business, regardless of whether such insurance income is
received from more than one controlled foreign corporation. This
approach is consistent with how NAICS would categorize the provision of
insurance (52--Finance and Insurance).
However, the proposed regulations do not permit the aggregation of
an exempt organization's insurance income included in UBTI under
section 512(b)(17) with any insubstantial commercial-type insurance
activities conducted directly by the exempt organization because the
controlled foreign corporation, not the exempt organization, is engaged
in the activity giving rise to the insurance income included in UBTI
under section 512(b)(17). The insurance activity is not attributed to
the exempt organization
[[Page 23186]]
and thus is distinguishable from any commercial-type insurance activity
engaged in directly by the exempt organization.
4. S Corporation Interest Treated as an Interest in an Unrelated Trade
or Business
An S corporation is a ``small corporation'' that may elect to be
treated under a simplified tax regime that acts as a hybrid between the
rules for corporations and the rules for pass-through entities. In
general, the items of income and loss of an S corporation are taxed
directly to the shareholders of that corporation. See section 1366(a).
The types of exempt organizations that are permitted to be shareholders
of an S corporation are described in section 1361(c)(2)(A)(vi) and (6).
Exempt organizations permitted to be S corporation shareholders include
qualified retirement plans, exempt organizations described in section
501(c)(3), and certain IRAs (including, subject to the limitation
described more specifically in 1361(c)(2)(A)(vi), an IRA designated as
a Roth IRA under section 408A).
For purposes of the unrelated business income tax, section 512(e)
provides special rules applicable to S corporations. Section
512(e)(1)(A) provides that, if an exempt organization permitted to be
an S corporation shareholder holds stock in an S corporation, such
interest will be treated as an interest in an unrelated trade or
business. Thus, notwithstanding any other provision in sections 511
through 514, section 512(e)(1)(B) requires an exempt organization
permitted to hold S corporation stock to take the following amounts
into account in computing the UBTI of such exempt organization: (i) All
items of income, loss, or deduction taken into account under section
1366(a) (regarding the determination of an S corporation shareholder's
tax liability); and (ii) any gain or loss on the disposition of the
stock in the S corporation.
Notice 2018-67 did not address, or request comments on, the
treatment of amounts taken into account in computing UBTI under section
512(e). Nonetheless, one commenter recommended that UBTI from an S
corporation should be treated as income from a single trade or business
regardless of the manner in which such income is earned by the S
corporation. The commenter stated that having to separate all the
income producing activities of an S corporation would be extremely
burdensome. Accordingly, the commenter recommended that all income from
an S corporation should be aggregated with the income from QPIs to
ensure similar treatment of all pass-through entities. In the
alternative, the commenter suggested combining all income from S
corporations in which the exempt organization shareholder owns less
than 50 percent of the shares with the income from QPIs.
The proposed regulations generally provide that each S corporation
interest will be treated as an interest in a separate unrelated trade
or business, which is consistent with the language of section
512(e)(1)(A). Accordingly, if an exempt organization has two S
corporation interests (that are not qualifying S corporation interests
described in section 4.a of this preamble), the exempt organization
will report two trades or businesses, one for each S corporation
interest. The treatment of each S corporation interest as one trade or
business for purposes of section 512(a)(6) is similar to the treatment
of specified payments from a controlled entity under section
512(b)(13). Furthermore, the Treasury Department and the IRS view this
treatment as best serving the purposes of section 512(a)(6).
Section 512(e) provides two different rules: One for items of
income, loss, or deduction taken into account under section 1366(a) and
one for any gain or loss on the disposition of S corporation stock.
Although these amounts could be treated as separate unrelated trades or
businesses for purposes of section 512(a)(6) due to the disparate
methods of inclusion in the language of section 512(e), such treatment
would artificially divide each S corporation interest into two trades
or businesses. The separate enumeration of the gain or loss on the
disposition of S corporation stock serves to override section
512(b)(5), which would otherwise exclude such gain or loss from the
calculation of UBTI, and not to indicate the existence of a separate
unrelated trade or business. Accordingly, the proposed regulations
provide that the UBTI from an S corporation interest is the amount
described in section 512(e)(1)(B), which includes both the items of
income, loss, or deduction taken into account under section 1366(a) and
the gain and loss on the disposition of S corporation stock.
a. Qualifying S Corporation Interests
Notwithstanding the general rule that each S corporation interest
is treated as a separate unrelated trade or business, the Treasury
Department and the IRS recognize that an exempt organization may hold S
corporation stock for different purposes, including investment
purposes. Additionally, the look-through treatment of an S corporation
is similar to the look-through treatment of a partnership. As discussed
in section 2.d of this preamble, these proposed regulations permit the
aggregation of QPIs to mitigate the burden on exempt organizations with
interests in multi-tier partnerships. Similarly, the proposed
regulations permit an exempt organization to aggregate its UBTI from an
S corporation interest with its UBTI from other investment activities
if the exempt organization's stock ownership (by percentage of stock
ownership) in the S corporation meets the requirements provided in the
de minimis test or the control test for ``qualifying partnership
interests.'' As such, if an exempt organization owns (by percentage of
stock ownership) 2 percent or less of the stock in an S Corporation,
or, if it owns 20 percent or less of the stock in such S corporation
and meets the facts and circumstances requirements under the second
prong of the control test, then such S corporation interest will be a
``qualifying S corporation interest'' and can be aggregated with other
investment activities. When determining an exempt organization's
percentage ownership of stock in an S corporation, the exempt
organization must apply the same rules for combining related interests
that are used to determine whether a partnership interest is a QPI. An
exempt organization may rely on the Schedule K-1 (Form 1120-S) that the
exempt organization receives from the S corporation when determining
its percentage ownership of the stock in such S corporation.
b. Employee Stock Ownership Plans
Section 512(e)(3) provides that section 512(e) does not apply to
employer securities (within the meaning of section 409(l)) held by an
employee stock ownership plan (ESOP) described in section 4975(e)(7).
ESOPs holding S corporation stock (``S corporation ESOPs'') are subject
to the limits imposed by section 409(p) on the concentration of S
corporation ownership. Ownership includes shares allocated to the
accounts of ESOP participants. Failing to meet the requirements of
section 409(p) will result in the imposition of an excise tax on the S
corporation and other adverse consequences to the ESOP and certain
individuals. Although section 512(e) generally does not apply to S
corporation ESOPs, the application of section 409(p) to an S
corporation ESOP might give rise to UBTI. The primary means of avoiding
a section 409(p) failure is for the S corporation ESOP to transfer some
of its S corporation shares
[[Page 23187]]
to a non-ESOP portion of the plan or to another qualified retirement
plan of the employer. See Sec. 1.409(p)-1(b)(2)(v)(A)-(B). Such a
transfer may result in a significant number of S corporation shares
being held by the non-ESOP portion of an S corporation ESOP or by
another section 401(a) plan (``transferee plan''). The transferred
shares, no longer held in an ESOP, are not described in section
512(e)(3). Accordingly, the transferee plan treats the S corporation
interest resulting from the transfer of the S corporation shares as an
interest in an unrelated trade or business under the general rule of
section 512(e)(1) and takes the amounts described in section
512(e)(1)(B) into account in computing UBTI. The Treasury Department
and IRS anticipate that a transferee plan is not likely to have more
than one S corporation interest. However, whether such S corporation
interest may be aggregated with the investment activities of the
transferee plan will depend on whether the S corporation interest is a
qualifying S corporation interest. The Treasury Department and the IRS
request comments on this issue.
5. Social Clubs, Voluntary Employees' Beneficiary Associations, and
Supplemental Unemployment Benefits Trusts
As noted in the Background section, section 512(a)(3) provides a
special definition of UBTI for social clubs, VEBAs, and SUBs. Section
512(a)(3)(A) defines UBTI, in part, as ``gross income (excluding exempt
function income).'' ``Gross income'' under section 61(a) includes
``gains derived from dealings in property,'' ``interest,'' ``rents,''
``royalties,'' ``dividends,'' and ``annuities.'' See section 61(a)(3)
through (8). Consistent with section 61(a), the gross income subject to
the unrelated business income tax under section 512(a)(3) generally
includes interest, annuities, dividends, royalties, rents, and capital
gains because the modifications in section 512(b)(1), (2), (3), and (5)
that exclude such amounts from UBTI for organizations subject to
section 512(a)(1) are not available under section 512(a)(3).
Accordingly, social clubs, VEBAs, and SUBs generally must include
interest, dividends, royalties, rents, and capital gains in UBTI unless
such amounts may be set aside for a purpose described in section
512(a)(3)(B)(i) or (ii) and therefore would be exempt function income
excluded from UBTI under section 512(a)(3)(A).
Section 512(a)(3)(B) defines ``exempt function income'' as (1)
``the gross income from dues, fees, charges, or similar amounts paid by
members of the organization as consideration for providing such members
or their dependents or guests goods, facilities, or services in
furtherance of the purposes constituting the basis for the exemption of
the organization;'' and (2) ``all income (other than an amount equal to
the gross income derived from any unrelated trade or business regularly
carried on by such organization computed as if the organization were
subject to [section 512(a)(1)]) which is set aside'' for one of the
purposes described in section 512(a)(3)(B)(i) or (ii). Such amounts set
aside include reasonable costs of administration directly connected
with a purpose described in section 512(a)(3)(B)(i) or (ii).
Section 512(a)(3)(B)(i) includes in exempt function income amounts
set aside for a purpose specified in section 170(c)(4), that is,
exclusively for religious, charitable, scientific, literary, or
educational purposes. In the case of a VEBA or SUB, section
512(a)(3)(B)(ii) includes in exempt function income amounts set aside
to provide for the payment of life, sick, accident, or other benefits.
Section 512(a)(3)(E) limits the amounts that may be set aside under
section 512(a)(3)(B)(ii). In general, section 512(a)(3)(E)(i) provides
that a set aside for any purpose described in section 512(a)(3)(B)(ii)
may be taken into account as exempt function income only to the extent
that such set aside does not result in an amount of assets set aside
for such purpose in excess of the account limit determined under
section 419A (without regard to section 419A(f)(6)) for the taxable
year (not taking into account any reserve described in section
419A(c)(2)(A) for post-retirement medical benefits).
In determining what income may be set aside under 512(a)(3)(B)(i)
or (ii), the income available is ``all income (other than an amount
equal to the gross income derived from any unrelated trade or business
regularly carried on by such organization computed as if the
organization were subject to [section 512(a)(1)]).'' This parenthetical
language, by referencing ``the gross income from any unrelated trade or
business computed as if the organization was subject to [section
512(a)(1)],'' pulls in the modifications of section 512(b) applicable
to that computation. Accordingly, amounts excluded from UBTI under
section 512(a) via the modifications in section 512(b) (such as
interest, dividends royalties, rents, and capital gains) are available
to be set aside for the purposes of section 512(a)(3)(B)(i) and (ii)
and may constitute exempt function income, subject to the other
applicable limitations.
For example, if a social club has interest and dividends, and does
not set aside any amount of such interest or dividends for a purpose
specified in section 170(c)(4), then the full amount of the interest
and dividends would constitute UBTI under section 512(a)(3). However,
if the social club sets aside any amount of the interest or dividends
for a purpose specified in section 170(c)(4), the amount of the
interest and dividends set aside would be excluded from the calculation
of UBTI under section 512(a)(3)(B)(i) as exempt function income
(provided that such amount set aside actually is used for a purpose
specified in section 170(c)(4)). Similarly, a VEBA with interest and
dividends may set aside amounts to provide for the payment of life,
sick, accident, or other benefits, subject to the limitations of
section 512(a)(3)(E).\4\ Such amount set aside will be excluded from
UBTI as exempt function income (provided that such amount actually is
used to provide for the payment of benefits).
---------------------------------------------------------------------------
\4\ See Treas. Reg. Sec. 1.512(a)-5(c).
---------------------------------------------------------------------------
Notice 2018-67 anticipated that the rules issued regarding how an
exempt organization identifies separate trades or businesses for
purposes of section 512(a)(6)(A) generally would apply under both
section 512(a)(1) and (3). Nonetheless, because social clubs, VEBAs,
and SUBs are taxed differently than other exempt organizations under
section 511, Notice 2018-67 requested comments regarding any additional
considerations that should be given to how section 512(a)(6) applies
within the context of section 512(a)(3), and, in particular, how the
income from investment activities of these organizations should be
treated for purposes of section 512(a)(6).
Commenters generally agreed that social clubs should be subject to
the same rules as exempt organizations subject to section 512(a)(1)
when determining whether the social club is subject to section
512(a)(6). A social club therefore would identify its unrelated trades
or businesses using NAICS codes and treat the income derived from
investment activities as a separate unrelated trade or business. Only
one commenter addressed how section 512(a)(6) should apply to VEBAs.
This commenter suggested that VEBAs would not be subject to section
512(a)(6) because the unrelated trade or business activities of the
VEBA could be identified under one NAICS 6-digit code--the code for
health and welfare funds (525120). However, as explained in section
1.a.i of this preamble, an exempt organization cannot use a
[[Page 23188]]
NAICS 2-digit code describing the activities the conduct of which is
substantially related to the exercise or performance by such exempt
organization of the purpose or function constituting the basis for its
exemption under section 501. No commenter addressed how section
512(a)(6) should apply to a SUB.
Consistent with the statement made in Notice 2018-67, the Treasury
Department and the IRS have determined that a social club, VEBA, or SUB
will determine whether it has more than one unrelated trade or business
in the same manner as an exempt organization subject to section
512(a)(1) except as discussed in sections 5.a and b of this preamble.
a. Investment Activities
As discussed in section 2 of this preamble, the proposed
regulations treat certain ``investment activities'' (that is, QPIs,
qualifying S corporation interests, and debt-financed property or
properties) as a separate unrelated trade or business for purposes of
section 512(a)(6) and the proposed regulations. Thus, a social club,
VEBA, or SUB generally will treat the investment activities
specifically listed in the proposed regulations as a separate unrelated
trade or business for purposes of section 512(a)(6). Nonetheless,
because UBTI is defined differently for social clubs, VEBAs, and SUBs,
the proposed regulations clarify that, in addition to other investment
activities treated as a separate unrelated trade or business for
purposes of section 512(a)(6), gross income from the investment
activities of a social club, VEBA, or SUB also includes specific
amounts discussed in sections 5.a.i. and ii of this preamble. The
Treasury Department and the IRS request comments regarding any
unintended consequences, in areas other than the unrelated business
income tax, resulting from the treatment of investment activity as an
unrelated trade or business for purposes of section 512(a)(6) for VEBAs
and SUBs.
i. Amounts Described in Section 512(b)(1), (2), (3), and (5)
Because the modifications in section 512(b)(1), (2), (3), and (5)
are not available under section 512(a)(3), social clubs, VEBAs, and
SUBs generally must include interest, dividends, royalties, rents, and
capital gains in UBTI under section 512(a)(3)(A) unless such amounts
are set aside for a purpose described in section 512(a)(3)(B)(i) or
(ii).\5\ As stated in section 2.a of this preamble, interest,
dividends, royalties, rents, and capital gains generally are considered
income from investment activities. Accordingly, the proposed
regulations provide that, for purposes of section 512(a)(6), UBTI from
the investment activities of a social club, VEBA, or SUB includes any
amount that would be excluded from the calculation of UBTI under
section 512(b)(1), (2), (3), or (5) if the social club, VEBA, or SUB
were subject to section 512(a)(1).
---------------------------------------------------------------------------
\5\ As explained in the introduction to section 5 of this
preamble, treating the investment activities of a social club, VEBA,
or SUB as an unrelated trade or business for purposes of section
512(a)(6) does not affect the amounts that may be set aside under
section 512(a)(3)(B)(i) or (ii).
---------------------------------------------------------------------------
ii. Amounts Set Aside but Used for Another Purpose and Amounts in
Excess of Account Limits
Section 512(a)(3)(B) provides that, if an amount which is
attributable to income set aside for a purpose described in section
512(a)(3)(B)(i) or (ii) is used for a purpose other than one described
therein, such amount shall be included in UBTI under section
512(a)(3)(A). Furthermore, with respect to a VEBA or SUB, the amount
set aside may not be in excess of the set aside limit under section
512(a)(3)(E) and any amount in excess of this limit is nonexempt
function income included in UBTI under section 512(a)(3)(A).
As discussed in section 5.a.i of this preamble, the amounts that
may be set aside under section 512(a)(3)(B)(i) or (ii) are part of the
social club, VEBA, or SUB's investment activities. Therefore, the
proposed regulations also provide that UBTI from the investment
activities of a social club, VEBA, or SUB includes any amount that is
attributable to income set aside (and not in excess of the set aside
limit described in section 512(a)(3)(E)), but not used, for a purpose
described in section 512(a)(3)(B)(i) or (ii) and any amount in excess
of the set aside limit described in section 512(a)(3)(E).
b. Social Club Activities
i. Limitation on Investment Activities
Notice 2018-67 provided that the interim and transition rules for
certain partnership interests did not apply to social clubs described
in section 501(c)(7), pending receipt of comments and additional
consideration of the issues specific to social clubs. Section 501(c)(7)
requires that ``substantially all of the activities'' of an
organization described therein be ``for pleasure, recreation, and other
nonprofitable purposes.'' Accordingly, a social club has specific
limits on the amount of nonexempt function income that may be earned
without endangering its tax-exempt status. While the Code does not
provide more detail, intended limits are described in legislative
history. See S. Rep. No. 94-1318 (1976), at 4-5. Additionally, Congress
did not intend social clubs to receive, within these limits, non-
traditional, unrelated business income. Id. Accordingly, consistent
with Notice 2018-67, the proposed regulations provide that the QPI rule
and the transition rule do not apply to social clubs because social
clubs should not be invested in partnerships that would generally be
conducting non-traditional, unrelated trades or businesses that
generate more than a de minimis amount of UBTI. In this regard, a
partnership interest meeting the requirements of the de minimis rule in
these proposed regulations is not the same as a partnership interest
generating only de minimis amounts of UBTI from non-traditional,
unrelated trades or businesses. Thus, the Treasury Department and the
IRS do not consider the administrative convenience rationale supporting
the QPI rule as relevant for social clubs.
ii. Nonmember Activities
Two commenters requested that a social club be permitted to treat
all nonmember activities as one unrelated trade or business for
purposes of section 512(a)(6). One of these commenters argued that a
social club could not easily separate its nonmember activities into
separate unrelated trades or businesses because social clubs do not
generally maintain separate books and records for the various locations
in which sales to nonmembers may occur, such as in dining facilities or
retail stores. The other commenter added that separating a social
club's nonmember activities into more than one unrelated trade or
business would result in substantial administrative burden. The
commenters describe the variety of activities in which social clubs
engage, including food and beverage sales in club dining facilities and
on club grounds (such as at pools or on golf courses and tennis
courts); retail sales; greens fees; and space rental fees, whether or
not they include substantial services.
As generally discussed in section 5 of this preamble, under the
proposed regulations, a social club with nonmember income is subject to
the same rules for identifying its unrelated trades or businesses as an
organization subject to the rules of section 512(a)(1). Further, as
discussed in section 1.a.i of this preamble, a social club cannot use
[[Page 23189]]
the NAICS 2-digit code generally describing social clubs (71) to
describe all its non-member income because the NAICS code used must
describe its separate unrelated trade or business and not the purpose
for which it is exempt. While this code may describe some of a social
club's non-member income, such as greens fees, other NAICS codes are
more appropriate to describe other non-member income, such as
merchandise sales (45) and food and beverage services (72).
Accordingly, a social club must identify its separate unrelated trades
or businesses in accordance with the rule described in section 1 of
this preamble like an exempt organization subject to section 512(a)(1).
iii. Nonrecurring Events
The Treasury Department and the IRS recognize that UBTI within the
meaning of section 512(a)(3) includes gross income without regard to a
specific determination regarding the associated activities'
qualification as an unrelated trade or business (within the meaning of
section 513) because UBTI under section 512(a)(3) includes ``all gross
income (excluding exempt function income).'' For example, one commenter
requested guidance on how to treat income from social club events that
are not anticipated to reoccur. The commenter provides as an example
the hosting of a professional golf tournament when similar tournaments
are not held in the same location on an annual basis. The commenter
suggested that events such that occur once, or seldom, in the life of a
social club, should be classified as a single trade or business under
section 512(a)(6).
As explained in section 1.a of this preamble, these proposed
regulations generally require an exempt organization to identify its
separate unrelated trades or businesses using the NAICS 2-digit code
that most accurately describes each trade or business. Whether an
infrequent or possibly nonrecurring event constitutes a separate
unrelated trade or business or whether such event is part of another
trade or business (including, in some cases, part of the social club's
investment activities) depends on the facts and circumstances of each
social club and the event at issue, including the scope of activities
as part of the event. While such determination is not necessary for
including such income in UBTI under section 512(a)(3), identification
of separate unrelated trades or businesses is necessary for applying
section 512(a)(6). The Treasury Department and the IRS request comments
regarding the particular facts and circumstances that should be
considered by a social club when determining whether a non-recurring
event should be treated as a separate unrelated trade or business, part
of a larger trade or business, or as part of a social club's investment
activities for purposes of section 512(a)(6).
iv. Activities Without a Profit Motive
One commenter requested that the Treasury Department and the IRS
clarify that nonmember activities conducted without intent to profit
are not unrelated trades or businesses. The Treasury Department and the
IRS do not address this comment in the proposed regulations because it
is adequately addressed by existing precedent. See, e.g., Portland Golf
Club, 497 U.S. at 164 (1990); Rev. Rul. 81-69, 1981-1 C.B. 351.
6. Total UBTI and the Charitable Contribution Deduction
Consistent with section 512(a)(6)(B), the proposed regulations
provide that the total UBTI of an exempt organization with more than
one unrelated trade or business is the sum of the UBTI computed with
respect to each separate unrelated trade or business (as identified
under the proposed regulations), less the specific deduction under
section 512(b)(12). The proposed regulations also state that, for
purposes of calculating an exempt organization's total UBTI, the UBTI
with respect to any separate unrelated trade or business identified
under the proposed regulations shall not be less than zero. See section
512(a)(6)(C).
Additionally, section 512(b)(10) and (11) permits exempt
organizations to take the deduction under section 170 for charitable
contributions whether or not the deduction is directly connected with
the carrying on of an unrelated trade or business. The deduction is
computed under section 170 except as otherwise provided in section
512(b)(10) and (11) and the Treasury regulations thereunder. For an
exempt organization described in section 511(a), the deduction allowed
by section 170 is limited to 10 percent of the exempt organization's
UBTI computed without the benefit of section 512(b)(10). For a trust
described in section 511(b), the deduction allowed by section 170 is
limited as prescribed by section 170(b)(1)(A) and (B) determined with
reference to UBTI computed without the benefit of section 512(b)(11).
At least one commenter recommended that the charitable contribution
deductions permitted under section 512(b)(10) and (11) be taken against
total UBTI calculated under section 512(a)(6)(B) rather than being
allocated among unrelated trades or businesses. Additionally, the JCT
stated that ``[i]t is not intended that an exempt organization that has
more than one unrelated trade or business be required to allocate its
deductible charitable contributions among its various unrelated trades
or businesses.'' General Explanation, at 293 n.1377. The Treasury
Department and the IRS agree. Thus, these proposed regulations clarify
in new Sec. 1.512(b)-1(g)(4) that the term ``unrelated business
taxable income'' as used in section 512(b)(10) and (11) refers to UBTI
after application of section 512(a)(6).
Under section 170(d)(1)(A), exempt organizations generally are
permitted to carry over charitable contributions that exceed the
organization's contribution base in a taxable year. Section
170(d)(1)(B) provides a special rule when an exempt organization has
both NOL carryovers and excess contributions. In the case of an exempt
organization with more than one unrelated trade or business, the
function of this special rule is complicated by the requirement in
section 512(a)(6)(A) to calculate NOLs separately with respect to each
trade or business (see section 7 of this preamble). The Treasury
Department and the IRS recognize that an ordering rule may be necessary
to clarify how the special rule in section 170(d)(1)(B) operates when
an exempt organization has NOL carry overs in more than one unrelated
trade or business. Accordingly, the Treasury Department and the IRS
request comments on this issue.
7. NOLs and UBTI
a. NOL Deduction Calculated Separately With Respect to Each Trade or
Business
Section 512(b)(6), which was not changed by the TCJA, generally
allows an exempt organization subject to the unrelated business income
tax under section 511, including an exempt organization with more than
one unrelated trade or business, to take the NOL deduction provided in
section 172. Section 512(b)(6)(A) states that the NOL for any taxable
year, the amount of the NOL carryback or carryover to any taxable year,
and the NOL deduction for any taxable year shall be determined under
section 172 without taking into account any amount of income or
deduction that is excluded under section 512(b) in computing UBTI. For
example, a loss attributable to an unrelated trade or business is not
to be reduced by reason of the receipt of dividend income. See Sec.
1.512(b)-1(e)(1). An NOL carryover is allowed only from
[[Page 23190]]
a taxable year for which the taxpayer is subject to the provisions of
section 511, or a corresponding provision of prior law. See section
512(b)(6)(B); Sec. 1.512(b)-1(e)(3).
Notice 2018-67 explained that section 512(a)(6) changes how an
exempt organization with more than one unrelated trade or business
calculates and takes NOLs into account with respect to a trade or
business. Specifically, section 512(a)(6)(A) requires such an exempt
organization to calculate UBTI, ``including for purposes of determining
any NOL deduction,'' separately with respect to each trade or business
for taxable years beginning after December 31, 2017. The legislative
intent behind this change is to allow an NOL deduction ``only with
respect to a trade or business from which the loss arose.'' H.R. Rep.
No. 115-466, at 547. Accordingly, consistent with the language of
section 512(a)(6)(A) and legislative intent, the proposed regulations
provide that an exempt organization with more than one unrelated trade
or business determines the NOL deduction allowed by sections 172(a) and
512(b)(6) separately with respect to each of its unrelated trades or
businesses. The proposed regulations clarify that, if an exempt
organization has more than one unrelated trade or business, Sec.
1.512(b)-1(e), which explains the application of section 172 within the
context of the unrelated business income tax, applies separately with
respect to each such unrelated trade or business. Additionally, the
proposed regulations add a new paragraph to Sec. 1.512(b)-1(e) that
refers an exempt organization with more than one unrelated trade or
business to new proposed Sec. 1.512(a)-6(h) regarding the computation
of the NOL deduction.
b. Coordination of NOLs
To preserve NOLs from tax years prior to the effective date of the
TCJA, Congress created a special transition rule for NOLs arising in a
taxable year beginning before January 1, 2018 (``pre-2018 NOLs'').
Section 13702(b)(2) of the TCJA provides that section 512(a)(6)(A) does
not apply to pre-2018 NOLs; rather, pre-2018 NOLs are taken against the
total UBTI calculated under section 512(a)(6)(B). However, when an
exempt organization has pre-2018 NOLs, which are subject to a carry-
forward limitation, and NOLs arising in a taxable year beginning after
December 31, 2017 (``post-2017 NOLs''), which are not, a question
arises regarding the order in which such losses should be taken.
In Notice 2018-67, the Treasury Department and the IRS noted that
section 512(a)(6) may have changed the order in which an organization
would ordinarily take losses. For example, if section 512(a)(6) is read
as a more specific ordering rule for purposes of calculating and taking
the NOL deduction than the one found in section 172, post-2017 NOLs
would be calculated and taken before pre-2018 NOLs because the UBTI
with respect to each separate unrelated trade or business is calculated
under section 512(a)(6)(A) before calculating total UBTI under section
512(a)(6)(B). Accordingly, Notice 2018-67 requested comments regarding
how the NOL deduction should be taken under section 512(a)(6) by exempt
organizations with more than one unrelated trade or business and, in
particular, by such organizations with both pre-2018 and post-2017
NOLs. Notice 2018-67 also requested comments on the ordering of pre-
2018 and post-2017 NOLs and the potential treatment of pre-2018 NOLs
that may expire in a given tax year if not taken before post-2017 NOLs.
In response to Notice 2018-67, several commenters addressed
possible ordering rules for organizations subject to section 512(a)(6).
These commenters noted that the language should not alter the ordering
rules under section 172 such that pre-2018 NOLs should be allowed prior
to post-2017 NOLs, especially because pre-2018 NOLs remain subject to a
carry-forward limitation.
The language of section 512(a)(6) and section 13702(b) of the TCJA
do not alter the ordering rules under section 172. Accordingly, the
proposed regulations provide that an exempt organization with both pre-
2018 and post-2017 NOLs will deduct its pre-2018 NOLs from its total
UBTI under section 512(a)(6)(B) before deducting any post-2017 NOLs
with regard to a separate unrelated trade or business from the UBTI
from such unrelated trade or business. The proposed regulations clarify
that pre-2018 NOLs are deducted from total UBTI in the manner that
results in maximum utilization of the pre-2018 NOLs in a taxable year.
c. Legislative Changes to Section 172
At the same time Congress added section 512(a)(6), it also made
extensive changes to section 172. These changes included limiting the
NOL deduction to 80 percent of taxable income, prohibiting the
carryback of NOLs (except for certain farming losses and in the case of
certain insurance companies), and allowing the indefinite carryover of
NOLs. Id. However, shortly before publication of these proposed
regulations, Congress enacted the Coronavirus Aid, Relief, and Economic
Security Act, Public Law 116-136, 134 Stat. 281 (2020) (CARES Act).
Section 2303 of the CARES Act temporarily repeals the 80 percent income
limitation and permits the carryback of NOLs arising in taxable years
beginning after December 31, 2017, and before January 1, 2021, to each
of the five taxable years preceding the taxable year of such loss. The
Treasury Department and the IRS will further consider how the changes
to section 172 made by the CARES Act affect the calculation of UBTI
under section 512(a)(6) and may issue additional guidance on the issue.
8. Form 990-T
One commenter suggested updating the Form 990-T to provide space
for an exempt organization to disclose and describe the method chosen
for identifying the separate unrelated trades or businesses being
reported on Form 990-T. This commenter recommended either the addition
of a ``miscellaneous schedule'' similar to Schedule O, ``Supplemental
Information to Form 990 or 990-EZ,'' of the Form 990, ``Return of
Organization Exempt from Income Tax,'' or the inclusion of space on the
schedules to the Form 990-T to make such disclosure. This commenter
also recommended that the IRS update the instructions to the Form 990-T
either to include a more complete list of applicable NAICS codes or to
state clearly where additional codes may be found. The Treasury
Department and the IRS recognize that changes to the Form 990-T and
related schedules may be necessary. In particular, the Treasury
Department and the IRS recognize that additional instructions are
required regarding how separate unrelated trades or businesses
identified under the special rules (rather than NAICS)--such as for
investment activities (see section 2 of this preamble), inclusions of
income derived from certain controlled entities (see section 3 of this
preamble), and non-qualifying S corporation interests (see section 4 of
this preamble)--are identified on Form 990-T and related schedules.
Accordingly, the IRS intends to update the Form 990-T and related
schedules, and the instructions thereto, as appropriate.
9. Individual Retirement Accounts
As previously discussed in the Background section of this preamble,
section 513(b) provides a special definition of ``unrelated trade or
business'' for a qualified retirement plan or for a trust that is
exempt from tax under section 501(c)(17) (SUB). Section 513(b) defines
``unrelated trade or business,'' as any trade or business
[[Page 23191]]
regularly carried on by such trust or by a partnership of which it is a
member.
Notice 2018-67 stated in a footnote that, because IRAs described in
section 408 are, under section 408(e), subject to the tax imposed by
section 511, and IRAs are most similar to qualified retirement plans,
it is reasonable to apply the definition of ``unrelated trade or
business'' described in section 513(b) to IRAs. The footnote stated
that the Treasury Department and the IRS intended to provide that the
section 513(b) definition of unrelated trade or business should be used
for IRAs subject to the unrelated business income tax in section 511
pursuant to section 408(e). Consistent with this statement, the
proposed regulations add a new paragraph to Sec. 1.513-1 clarifying
that the section 513(b) definition of ``unrelated trade or business''
applies to IRAs. Accordingly, Sec. 1.513-1(f) provides that an IRA
will apply the definition of ``unrelated trade or business'' in section
513(b) when determining whether it has more than one unrelated trade or
business within the meaning of section 512(a)(6). The proposed
regulations make corresponding changes to Sec. 1.513(b)-1(a) to
account for the new paragraph added at Sec. 1.513(b)-1(f).
10. Inclusions of Subpart F Income and Global Intangible Low-Taxed
Income
An inclusion of subpart F income under section 951(a)(1)(A) is
treated in the same manner as a dividend for purposes of section
512(b)(1). Accordingly, an inclusion of subpart F income generally is
excluded from the calculation of UBTI under section 512(b)(1). Notice
2018-67 explained that Congress approved the IRS's long-standing
position when Congress enacted section 512(b)(17). Furthermore, Notice
2018-67 provided that an inclusion of GILTI under section 951A(a)
should be treated in the same manner as an inclusion of subpart F
income under section 951(a)(1)(A) for purposes of section 512(b)(1) and
therefore would be treated as a dividend that generally is excluded
from UBTI. Two commenters explicitly agreed with these conclusions and
one commenter requested that the Treasury Department and the IRS revise
the Treasury Regulations consistent with these conclusions.
Accordingly, the proposed regulations revise Sec. 1.512(b)-1(a) to
clarify that an inclusion of subpart F income under section
951(a)(1)(A) is treated in the same manner as a dividend for purposes
of section 512(b)(1) and that an inclusion of GILTI under section
951A(a) is treated in the same manner as an inclusion of subpart F
income under section 951(a)(1)(A) for purposes of section 512(b)(1).
11. Public Support
A question has arisen regarding whether the enactment of section
512(a)(6) impacts the calculation of public support under sections
509(a)(1) and 170(b)(1)(A)(vi) and under section 509(a)(2). Exempt
organizations described in section 501(c)(3) that are classified as
publicly supported charities under these sections must calculate public
support annually on Form 990, Schedule A, ``Public Charity Status and
Public Support.'' In general, public support is expressed as a
percentage of support from certain public sources over total support.
See Sec. 1.170A-9(f) (definition of section 170(b)(1)(A)(vi)
organization); Sec. 1.509(a)-3 (publicly supported organizations).
Section 512(a)(6) potentially impacts two aspects of the public
support test. First, section 512(a)(6) potentially impacts the
calculation of total support under section 509(d), a number which is
used for purposes of both section 509(a)(1) and (2). Specifically,
section 509(d)(3) includes, in the calculation of total support, the
organization's net income from unrelated business activities, whether
or not such activities are carried on regularly as a trade or business.
Although section 509(d)(3) does not specifically cross-reference
section 512, the term ``unrelated business activities'' can be read
broadly to include, but not be limited to, UBTI within the meaning of
section 512. If this is the case, then an organization with more than
one unrelated trade or business could be required to apply section
512(a)(6) in determining its total support, which may increase its
amount of total support because the losses from one unrelated trade or
business cannot offset the gains from another unrelated trade or
business.
Second, section 512(a)(6) potentially impacts the not-more-than-
one-third support test under section 509(a)(2)(B), which requires
calculation of the excess (if any) of the amount of UBTI (as defined in
section 512) over the amount of the tax imposed by section 511. Unlike
section 509(d)(3), which does not cross-reference section 512, the not-
more-than-one-third support test specifically cross-references section
512. Accordingly, an organization with more than one unrelated trade or
business could be required to apply section 512(a)(6) when determining
whether it receives more than one-third of its support from non-public
sources. If this is the case, application of section 512(a)(6) in this
context may result in an increase in support received from non-public
sources, again, because of the inability to use losses from one
unrelated trade or business to offset income from another unrelated
trade or business.
If section 512(a)(6) applies in either context, organizations with
more than one unrelated trade or business may have difficulty
qualifying as publicly supported because of the potential increase in
the calculated support from non-public sources as well as the potential
increase in the calculated amount of total support. The Treasury
Department and the IRS are not aware of any intent of Congress to
change the public support test when enacting section 512(a)(6).
Accordingly, the proposed regulations include revisions to Sec. Sec.
1.170A-9(f) and 1.509(a)-3 to permit an organization with more than one
unrelated trade or business to aggregate its net income and net losses
from all of its unrelated business activities, including its unrelated
trades or businesses within the meaning of section 512, for purposes of
determining whether the organization is publicly supported. The
Treasury Department and the IRS recognize that requiring different
calculations for purposes of calculating public support and UBTI may
impose a significant administrative burden on organizations with more
than one unrelated trade or business. Accordingly, the Treasury
Department and the IRS request comments regarding the application of
section 512(a)(6) to the public support test.
12. Technical Correction of Inadvertently Omitted Regulatory Language
These proposed regulations make a technical correction to Sec.
1.512(a)-1(b). In 1967, the Treasury Department and the IRS published
Sec. 1.512(a)-1 in the Federal Register (TD 6939, 32 FR 17660).
Section 1.512(a)-1(b) explained that ``[e]xpenses, depreciation and
similar items attributable solely to the conduct of an unrelated
business are proximately and primarily related to that business and
therefore qualify for deduction to the extent that they meet the
requirements of section 162, section 167, or other relevant provisions
of the Internal Revenue Code.'' An example followed this statement
providing that, ``[t]hus, for example, salaries of personnel employed
full-time in carrying on an unrelated business are directly connected
with the conduct of the unrelated business and are deductible in
computing unrelated business taxable income if they otherwise qualify
for deduction under the requirements of section 162.''
[[Page 23192]]
In 1975, the Treasury Department and the IRS revised Sec.
1.512(a)-1(b) in regulations published in the Federal Register (TD
7392, 40 FR 58639). The final regulations omitted from the example the
following language: ``[t]hus, for example, salaries of personnel
employed full-time in carrying on an unrelated business are directly.''
However, the final regulations as published in the Cumulative Bulletin
(1976-1 CB 162) contained this language. Accordingly, the Treasury
Department and the IRS have concluded that this language was
inadvertently omitted from the final regulations in 1975 and are making
a technical correction to the regulations. Therefore, the proposed
regulations include the omitted language in Sec. 1.512(a)-1(b).
Proposed Applicability Dates
These regulations are proposed to apply to taxable years beginning
on or after the date these regulations are published in the Federal
Register as final regulations. For taxable years beginning before the
date these regulations are published in the Federal Register as final
regulations, an exempt organization may rely on a reasonable, good-
faith interpretation of sections 511 through 514, considering all the
facts and circumstances, when identifying separate unrelated trades or
businesses for purposes of section 512(a)(6)(A). In addition, for these
same taxable years, an exempt organization may rely on these proposed
regulations in their entirety. Alternatively, for these same taxable
years, an exempt organization may rely on the methods of aggregating or
identifying separate trades or businesses provided in the Notice 2018-
67.
Statement of Availability of IRS Documents
For copies of recently issued Revenue Procedures, Revenue Rulings,
Notices, and other guidance published in the Internal Revenue Bulletin,
please visit the IRS website at http://www.irs.gov or the
Superintendent of Documents, U.S. Government Printing Office,
Washington, DC 20402.
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
Executive Orders 12866, 13563, and 13771 direct agencies to assess
costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health, and safety effects; distributive impacts; and equity).
Executive Order 13563 emphasizes the importance of quantifying both
costs and benefits, of reducing costs, of harmonizing rules, and of
promoting flexibility.
The proposed regulations have been designated as significant under
Executive Order 12866 pursuant to the Memorandum of Agreement (April
11, 2018) between the Treasury Department and the Office of Management
and Budget (OMB) regarding review of tax regulations. The Office of
Information and Regulatory Affairs (OIRA) has designated the proposed
rulemaking as significant under section 1(b) of the Memorandum of
Agreement. Accordingly, the proposed regulations have been reviewed by
OMB. For purposes of Executive Order 13771, the proposed regulations
are regulatory.
A. Background
Certain corporations, trusts, and other entities are exempt from
Federal income taxation because of the specific functions they perform
(``exempt organizations''). Examples include religious and charitable
organizations. However, exempt organizations that engage in business
activities that are not substantially related to their exempt purposes
may have taxable income under section 511(a)(1) of the Internal Revenue
Code (Code). For example, the income that a tax-exempt organization
generates from the sale of advertising in its quarterly magazine is
unrelated business taxable income (UBTI).
Prior to the Tax Cuts and Jobs Act (TCJA), UBTI was calculated by
aggregating the net incomes from all the unrelated business activities
conducted by an exempt organization. As a result, losses from one
activity could be used to offset profits from another activity. New
section 512(a)(6), enacted in the TCJA, provides that organizations
with more than one unrelated trade or business calculate the taxable
amounts separately for each trade or business so that losses only
offset income from the same unrelated trade or business. The statutory
language, however, does not specify standards for determining what
activities would be considered the same or a different trade or
business.
Previously, on September 4, 2018, the Treasury Department and the
IRS published Notice 2018-67, 2018-36 I.R.B. 409 (the Notice), which
discussed and solicited comments regarding various issues arising under
section 512(a)(6) and set forth interim guidance and transition rules
relating to that section. The Treasury Department and the IRS received
24 comments in response to the Notice. The proposed regulations
consider and respond to these comments.
The proposed regulations address the need for guidance by providing
rules for determining when an exempt organization has more than one
unrelated trade or business and how such an exempt organization
computes UBTI under new section 512(a)(6). Specifically discussed
below, the proposed regulations establish guidelines for (1)
identifying separate unrelated trades or businesses; and (2) in certain
cases, permitting an exempt organization to treat investment activities
as one unrelated trade or business for purposes of computing UBTI.
B. Baseline
The Treasury Department has assessed the benefits and costs of the
proposed regulations relative to a no-action baseline reflecting
anticipated Federal income tax-related behavior in the absence of these
regulations.
C. Affected Entities
Prior tax law did not require reporting unrelated business income
by separate activity so taxpayer counts are not available. However, the
IRS estimates that less than 2 percent of exempt organizations would be
affected. Potentially affected organizations are only those with more
than one unrelated trade or business, a group likely to include
colleges and universities, certain cultural organizations such as
museums, and some tax-exempt hospitals.
Presently it is not possible to obtain accurate counts of the
number of exempt organizations potentially affected by the proposed
regulations, because prior law did not require disaggregation of the
separate sources of UBTI and therefore the IRS does not have access to
this level of detail on UBTI. Approximately 1.4 million exempt
organizations filed some type of information or tax return with the IRS
for fiscal year 2018.\6\ Only 188,000 exempt organizations filed Form
990-T, which is used to report UBTI. While not all Form 990-T filers
also file an information return with the IRS, as an
[[Page 23193]]
upper bound estimate 14 percent of exempt organizations could be
affected by the regulations. Within Form 990-T filers, only a smaller
subset, primarily the largest organizations in certain categories, are
expected to have more than one unrelated trade or business. Among the
types of organizations expected to have more than one unrelated trade
or business are colleges and universities, certain cultural
organizations such as museums, and some tax-exempt hospitals.
---------------------------------------------------------------------------
\6\ See Internal Revenue Service Research, Applied Analytics,
and Statistics, Statistics of Income Division Fiscal Year Return
Projections for the United States Publication 6292 (Rev. 9-2019),
Projected Returns 2019-2026. Exempt organizations generally must
file an annual information return with IRS. See generally section
6033. However, churches and small organizations are exempt from this
filing requirement. See section 6033(a)(3). Organizations that have
more than $1,000 in gross UBTI must also file Form 990-T to
calculate their UBTI and tax. See section 512(b)(12) (providing a
$1,000 specific deduction).
---------------------------------------------------------------------------
Additional information on organizations that may be affected is
provided by a 2018 Center on Nonprofits and Philanthropy (CNP) survey
of 723 primarily large exempt organizations.\7\ Three-hundred and
thirty of these organizations reported that they had filed a Form 990-
T. Of these, 70 percent had revenues over $10 million and most were
educational or arts and cultural organizations. Only 46 organizations
(14 percent of the surveyed organizations filing Form 990-T) reported
having more than one source of UBTI and almost half of these had only
two sources. Thus, the Treasury Department and the IRS project that if
the CNP survey results applied to the population of Form 990-T filers,
then less than 2 percent of exempt organizations would be affected by
the proposed regulations and that these would tend to be large
educational or arts and cultural organizations.
---------------------------------------------------------------------------
\7\ See Elizabeth Boris and Joseph Cordes, ``How the TCJA's New
UBIT Provisions Will Affect Nonprofits,'' Urban Institute Research
Report, January 2019.
---------------------------------------------------------------------------
D. Economic Analysis of NPRM
The proposed regulations provide greater certainty to exempt
organizations regarding how to compute UBTI and tax in response to the
changes made by TCJA and adopt standards that balance the statutory
intent of those changes and excessive burden that might result from
some interpretations of such standards. They also improve economic
efficiency by helping to ensure that similar exempt organizations are
taxed similarly. In the absence of this guidance taxpayers might make
different assumptions regarding how to calculate UBTI and tax.
This section describes the two provisions of the NPRM for which
economic analysis is helpful and provides a qualitative economic
analysis of each one.
i. Identifying Separate Trades or Businesses
As discussed above, section 512(a)(6) requires exempt organizations
with more than one unrelated trade or business to calculate UBTI
separately for each trade or business so that losses are only used to
offset income from the same unrelated trade or business. The Notice
stated that the Treasury Department and the IRS were considering the
use of NAICS codes to identify separate unrelated trades or businesses
and, in the meantime, would consider the use of NAICS 6-digit codes to
be reasonable for identifying separate unrelated trades or businesses.
NAICS is an industry classification system for purposes of collecting,
analyzing, and publishing statistical data related to the United States
business economy. Each digit of the NAICS 6-digit codes describes an
industry with increasing specificity.
In the Notice, the Treasury Department and the IRS requested
comments regarding methods to identify separate unrelated trades or
businesses in general and the use of NAICS codes in particular. As
discussed further below, several commenters pointed out potential
difficulties in using NAICS 6-digit codes and suggested using NAICS 2-
or 3-digit codes; that is, a higher level of aggregation of business
activity. The proposed regulations allow the use of NAICS 2-digit
codes, thereby addressing the concerns raised in comments received and
reducing compliance burdens for exempt organizations with multiple
similar types of business activity.
Several commenters stated that the NAICS codes represented a
workable system for identifying a separate unrelated trade or business.
Not all commenters agreed as to what level of these codes should be
used to group the various activities. Most of the commenters making
recommendations on the NAICS codes rejected the use of NAICS 6-digit
codes. These commenters noted that using NAICS 6-digit codes would
result in significant compliance burden because an exempt organization
would have to determine which of over 1,000 NAICS 6-digit codes most
accurately describes its trades or businesses. Commenters noted that
many NAICS 6-digit codes may apply to more than one trade or business
activity or that no NAICS 6-digit code may exist to accurately describe
a trade or business activity. Additionally, these commenters argued
that the use of NAICS 6-digit codes could potentially require an exempt
organization to split what has traditionally been considered one
unrelated trade or business into multiple unrelated trades or
businesses. Some commenters noted they would have to incur the costs of
changing their accounting systems so as to collect the information
needed for separate NAICS 6-digit codes. These commenters suggested a
range of code levels representing various levels of specificity from 2-
digits up to 4-digits.
Reflecting comments on the Notice from potentially affected
organizations, the Treasury Department and the IRS chose NAICS 2-digit
codes for identifying unrelated trades or businesses. Allowing the use
of NAICS 2-digit codes to identify separate unrelated trades or
businesses reduces the compliance costs of affected organizations
relative to the use of NAICS 6-digit codes. For example, different
types of food services would be in the same NAICS 2-digit code as
opposed to separate NAICS 6-digit codes. Similarly, different types of
recreational activities, such as fitness centers and golf courses,
would be in the same NAICS 2-digit code as opposed to separate NAICS 6-
digit codes. A single facility might have elements fitting several of
these categories, which could change over time when NAICS codes are
revised.
The guidance provided in the proposed regulations also ensures that
the tax liability is calculated similarly across taxpayers, avoiding
situations where one taxpayer receives differential treatment compared
to another taxpayer for fundamentally similar economic activity based
on their differing reasonable, good-faith interpretation of the
statute. In the absence of these proposed regulations, an exempt
organization might be uncertain about whether an activity is one or
more than one business activity. As a result, in the absence of the
proposed regulations, similar institutions might take different
positions and pay different amounts of tax, introducing economic
inefficiency and inequity.
Since exempt organizations could use a reasonable and good-faith
effort to interpret whether some trade and business activities would
have to be reported separately, behavioral responses were likely muted.
These regulations do provide greater certainty and flexibility such
that compliance costs may be slightly lower for affected organizations.
The Treasury Department and the IRS solicit comments on the use of
the NAICS 2-digit codes and comments that provide data, other evidence,
or models that would enhance the rigor by which the final regulations
might be developed.
ii. Aggregation of Investment Activities
The proposed regulation's treatment of investment activities will
also provide clarity and reduce burdens for
[[Page 23194]]
exempt organizations. By providing more explicit rules for the
treatment of investment activities, the proposed regulations reduce the
uncertainty about what would be acceptable under the ``reasonable,
good-faith interpretation'' provided in the Notice. Although investment
income, such as interest and dividend income, is not generally taxed as
UBTI, exempt organizations may engage in certain activities that the
organization considers ``investments'' but that generate UBTI, such as
debt-financed investments or investments through partnerships.
Consistent with the guidance included in the Notice, the proposed
regulations allow certain of this ``investment'' income to be
aggregated and treated as a single trade or business. The proposed
regulations further expand on the notice by providing a more developed
rule for partnership income and explicitly list the other types of UBTI
that can be aggregated as ``investment'' income in response to comments
requesting additional clarification. As a result, the proposed
regulations reduce the compliance burdens of exempt organizations of
obtaining information from partnerships and simplify the calculation of
UBTI when the income is generated from ``investment'' activities
relative to the no-action baseline.
Given these proposed regulations follow and slightly expand the
guidance in the Notice, investment responses are likely to be minimal.
While some exempt organizations may have perceived a need to reorganize
certain investments, such as in partnerships that qualify for aggregate
treatment and thereby seek offset any losses, few would have been
expected to do this reorganization prior to regulations being
published.
iii. Summary
The proposed regulations provide rules for determining when an
exempt organization has more than one unrelated trade or business and
how such an exempt organization computes UBTI. In addition, the
proposed regulations provide guidelines for when an exempt organization
treats its investment activities as one unrelated trade or business for
purposes of computing UBTI. In the absence of guidance, affected
taxpayers may face more uncertainty when calculating their tax
liability, a situation generally that could lead to greater conflicts
with tax administrators. The Treasury Department and the IRS project
that the proposed regulations will reduce taxpayer compliance burden
relative to the no-action baseline. In addition, the Treasury
Department and the IRS project that these regulations will affect a
small number of exempt organizations. Based on this analysis, the
Treasury Department and the IRS anticipate any economic effects of the
proposed regulations will be modest.
II. Paperwork Reduction Act
The collection of information in these proposed regulations is in
Sec. 1.512(b)-6(a). This information is required to determine whether
an exempt organization has more than one unrelated trade or business
and therefore must report those unrelated trades or businesses on Form
990-T and related schedules. In 2018, the IRS released and invited
comments on drafts of an earlier version of the Form 990-T and related
schedules to give members of the public opportunity to comment on
changes made to the Form 990-T, and the addition of a new schedule to
report additional unrelated trades or businesses, as required by the
enactment of section 512(a)(6). The IRS received no comments on the
Form 990-T and related schedules during that comment period.
Consequently, the IRS made Form 990-T available on January 8, 2019, and
the new schedule for reporting additional unrelated trades or
businesses available on January 25, 2019, for use by the public. The
IRS intends that the burden of collections of information will be
reflected in the burden associated with the Form 990 series under OMB
approval number 1545-0047.
The paperwork burden estimate for tax-exempt organizations is
reported under OMB control number 1545-0047, which represents a total
estimated burden time, including all other related forms and schedules
for corporations, of 52 billion hours and total estimated monetized
costs of $4.17 billion ($2017). The burden estimates provided in the
OMB control number are aggregate amounts that relate to the entire
package of forms associated with the OMB control number and will in the
future include, but not isolate, the estimated burden of these proposed
regulations. These numbers are therefore unrelated to the future
calculations needed to assess the burden imposed by adoption of these
proposed regulations. The Treasury Department and IRS urge readers to
recognize that these numbers are duplicates and to guard against
overcounting the burden. No burden estimates specific to the proposed
regulations are currently available. The Treasury Department has not
estimated the burden, including that of any new information
collections, related to the requirements under the proposed
regulations. Those estimates would capture both changes made by the Act
and those that arise out of discretionary authority exercised in the
proposed regulations. The current status of the Paperwork Reduction Act
submissions related to these proposed regulations is provided in the
following table.
------------------------------------------------------------------------
Form OMB control No. Status
------------------------------------------------------------------------
990 and related forms......... 1545-0047........ Sixty-day notice
published on 9/24/
2019. Thirty-day
notice published on
12/31/2019. Approved
by OIRA on 2/12/
2020.
-----------------------------------------
Link: https://www.irs.gov/forms-pubs/about-form-990.
------------------------------------------------------------------------
The Treasury Department and the IRS request comments on all aspects
of information collection burdens related to the proposed regulations,
including estimates for how much time it would take to comply with the
paperwork burdens described above for each relevant form and ways for
the IRS to minimize the paperwork burden. Proposed revisions (if any)
to the Form 990-T and related schedules that reflect the information
collections contained in these proposed regulations will be made
available for public comment at http://apps.irs.gov/app/picklist/list/draftTaxForms.html. The revised Form 990-T and related schedules will
not be finalized until after these forms have been approved by OMB
under the PRA. Comments on these forms can be submitted at https://www.irs.gov/forms-pubs/comment-on-tax-forms-and-publications.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may
[[Page 23195]]
become material in the administration of any internal revenue laws.
Generally, tax returns and return information are confidential, as
required by 26 U.S.C. 6103.
III. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6)
(RFA), it is hereby certified that these proposed regulations would not
have a significant economic impact on a substantial number of small
entities. As discussed elsewhere in this preamble, these proposed
regulations apply to all exempt organizations with UBTI, but only to
the extent required to determine if an exempt organization has more
than one unrelated trade or business. If an exempt organization only
has one unrelated trade or business, these regulations do not apply and
the exempt organization determines UBTI under section 512(a)(1) or
section 512(a)(3), as appropriate. If an exempt organization has more
than one unrelated trade or business, these proposed regulations
provide instructions for computing UBTI separately with respect to each
such unrelated trade or business.
These proposed regulations are not likely to affect a substantial
number of small entities. According to the IRS Data Book, 1,835,534
exempt organizations existed in 2018. Internal Revenue Service,
Publication 55B, Internal Revenue Service Data Book 2018, 57 (May
2019). However, only 188,334 Form 990-Ts were filed in 2018. Internal
Revenue Service, Publication 6292, Fiscal Year Return Projects for the
United States: 2019-2026, Fall 2019 4 (September 2019). The IRS expects
that less than 10 percent of the exempt organizations population will
be affected by these proposed regulations because the exempt
organizations filing Form 990-T include entities not included in the
definition of ``small entities,'' such as large hospital systems and
universities. Therefore, this proposed regulation is not likely to
affect a substantial number of small entities.
Even if the regulations affected a substantial number of small
entities, the economic impact of this proposed rule is not likely to be
significant. An organization affected by this rule, with more than one
unrelated trade or business, completes Part I and Part II on page 1 of
Form 990-T and completes and attaches a separate schedule for each
additional unrelated trade or business. Affected taxpayers have been
reporting UBTI on form 990-T for the previous two tax years. As
discussed elsewhere in this preamble, these regulations would provide
certainty and guidance for these organizations. In the absence of this
guidance, affected taxpayers may face more uncertainty when calculating
their tax liability, a situation generally that could lead to greater
conflicts with tax administrators. Although affected taxpayers will
have to spend time reading and understanding these regulations, the
Treasury Department and the IRS project that the proposed regulations
provide certainty and guidance that will reduce taxpayer compliance
burden for large and small entity taxpayers.
Notwithstanding this certification, the Treasury Department and the
IRS invite comments on the impact this rule may have on small entities.
Pursuant to section 7805(f), this proposed rule has been submitted
to the Chief Counsel for Advocacy of the Small Business Administration
for comment on its impact on small entities.
Comments and Requests for Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are timely submitted
to the IRS as prescribed in the preamble under the ADDRESSES section.
All comments submitted will be made available at https://www.regulations.gov or upon request.
A public hearing on these proposed regulations will be scheduled if
requested in writing by any person who timely submits written comments.
If a public hearing is scheduled, notice of the date, time, and place
for the public hearing will be published in the Federal Register.
Drafting Information
The principal author of this notice of proposed rulemaking is
Stephanie N. Robbins, Office of the Chief Counsel (Employee Benefits,
Exempt Organizations and Employment Taxes). However, other personnel
from the Treasury Department and the IRS participated in their
development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.170A-9 is proposed to be amended by:
0
1. Adding new paragraph (f)(7)(v).
0
2. Adding new paragraph (k)(3).
The additions read as follows:
Sec. 1.170A-9 Definition of section 170(b)(1)(A) organization.
* * * * *
(f) * * *
(7) * * *
(v) Unrelated business activities. The term net income from
unrelated business activities in section 509(d)(3) includes (but is not
limited to) an organization's unrelated business taxable income (UBTI)
within the meaning of section 512. However, when calculating UBTI for
purposes of determining support (within the meaning of paragraph
(f)(7)(i) of this section), section 512(a)(6) does not apply.
Accordingly, in the case of an organization that derives gross income
from the regular conduct of two or more unrelated business activities,
support includes the aggregate of gross income from all such unrelated
business activities less the aggregate of the deductions allowed with
respect to all such unrelated business activities.
* * * * *
(k) * * *
(3) Applicability date. Paragraph (f)(7)(v) of this section applies
to taxable years beginning on or after [DATE OF PUBLICATION OF THE
FINAL RULES IN THE FEDERAL REGISTER].
0
Par. 3. Section 1.509(a)-3 is proposed to be amended by:
0
1. Revising the first sentence of paragraph (a)(3)(i).
0
2. Redesignating paragraph (a)(4) as paragraph (a)(5).
0
3. Adding new paragraph (a)(4).
0
4. Revising paragraph (o).
The revisions and additions read as follows:
Sec. 1.509(a)-3 Broadly, publicly supported organizations.
(a) * * *
(3) * * *
(i) * * * An organization will meet the not-more-than-one-third
support test under section 509(a)(2)(B) if it normally (within the
meaning of paragraph (c) or (d) of this section) receives not more than
one-third of its support in each taxable year from the sum of its gross
investment income (as defined in section 509(e)) and the excess (if
any) of the amount of its unrelated business taxable income (as defined
in section 512, without regard to section 512(a)(6)) derived from
trades or businesses that were acquired by the organization after June
30, 1975, over the amount of tax imposed on such income by section 511.
* * * * *
[[Page 23196]]
(4) Unrelated business activities. The denominator of the one-third
support fraction and the denominator of the not-more-than-one-third
support fraction both include net income from unrelated business
activities, whether or not such activities are carried on regularly as
a trade or business. The term net income from unrelated business
activities includes (but is not limited to) an organization's unrelated
business taxable income (UBTI) within the meaning of section 512.
However, when calculating UBTI for purposes of determining the
denominator of both support fractions, section 512(a)(6) does not
apply. Accordingly, in the case of an organization that derives gross
income from the regular conduct of two or more unrelated business
activities, support includes the aggregate of gross income from all
such unrelated business activities less the aggregate of the deductions
allowed with respect to all such unrelated business activities.
* * * * *
(o) Applicability date. This section generally applies to taxable
years beginning after December 31, 1969, except paragraphs (a)(3)(i)
and (a)(4) of this section apply to taxable years beginning on or after
[DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]. For
taxable years beginning before [DATE OF PUBLICATION OF THE FINAL RULES
IN THE FEDERAL REGISTER], see these paragraphs as in effect and
contained in 26 CFR part 1 revised as of April 1, 2019.
0
Par. 4. Section 1.512(a)-1 is proposed to be amended by:
0
1. Revising the first and fourth sentence of paragraph (a).
0
2. Revising the first and second sentence of paragraph (b).
0
3. Adding two sentences to the end of paragraph (c).
0
4. Revising paragraph (h).
The revisions and additions read as follows:
Sec. 1.512(a)-1 Definition.
(a) * * * Except as otherwise provided in Sec. 1.512(a)-3, Sec.
1.512(a)-4, or paragraph (f) of this section, section 512(a)(1) defines
unrelated business taxable income as the gross income derived from any
unrelated trade or business regularly carried on, less those deductions
allowed by chapter 1 of the Internal Revenue Code (Code) which are
directly connected with the carrying on of such trade or business,
subject to certain modifications referred to in Sec. 1.512(b)-1. * * *
In the case of an organization with more than one unrelated trade or
business, unrelated business taxable income is calculated separately
with respect to each such trade or business. See Sec. 1.512(a)-6. * *
*
(b) * * * Expenses, depreciation, and similar items attributable
solely to the conduct of unrelated business activities are proximately
and primarily related to that business activity, and therefore qualify
for deduction to the extent that they meet the requirements of section
162, section 167, or other relevant provisions of the Code. Thus, for
example, salaries of personnel employed full-time in carrying on
unrelated business activities are directly connected with the conduct
of that activity and are deductible in computing unrelated business
taxable income if they otherwise qualify for deduction under the
requirements of section 162.
(c) * * * However, allocation of expenses, depreciation, and
similar items using an unadjusted gross-to-gross method is not
reasonable. For example, if a social club charges nonmembers a higher
price than it charges members for the same good or service, it must
adjust the price of the good or service provided to members for
purposes of determining the allocation of indirect expenses to avoid
overstating the deductions allocable to the unrelated business activity
of providing goods and services to nonmembers.
* * * * *
(h) Applicability date. This section generally applies to taxable
years beginning after December 12, 1967, except as provided in
paragraph (g)(2) of this section, and except that paragraphs (a)
through (c) of this section apply to taxable years beginning on or
[DATE OF PUBLICATION OF THE FINAL RULES IN THE FEDERAL REGISTER]. For
taxable years beginning before [DATE OF PUBLICATION OF THE FINAL RULES
IN THE FEDERAL REGISTER], see these paragraphs as in effect and
contained in 26 CFR part 1 revised as of April 1, 2019.
0
Par. 5. Section 1.512(a)-6 is proposed to be added to read as follows:
Sec. 1.512 (a)-6 Special rule for organizations with more than one
unrelated trade or business.
(a) More than one unrelated trade or business--(1) In general. An
organization with more than one unrelated trade or business must
compute unrelated business taxable income (UBTI), including for
purposes of determining any net operating loss (NOL) deduction,
separately with respect to each such trade or business, without regard
to the specific deduction in section 512(b)(12). An organization with
more than one unrelated trade or business computes its total UBTI under
paragraph (g) of this section.
(2) Separate trades or businesses. For purposes of section
512(a)(6)(A) and paragraph (a)(1) of this section, an organization
identifies its separate unrelated trades or businesses using the
methods described in paragraphs (b) through (e) of this section.
(b) North American Industry Classification System--(1) In general.
Except as provided in paragraphs (c) through (e) of this section, an
organization will identify each of its separate unrelated trades or
businesses using the first two digits of the North American Industry
Classification System code (NAICS 2-digit code) that most accurately
describes the trade or business. The NAICS 2-digit code chosen must
identify the unrelated trade or business in which the organization
engages (directly or indirectly) and not the activities the conduct of
which are substantially related to the exercise or performance by such
organization of its charitable, educational, or other purpose or
function constituting the basis for its exemption under section 501
(or, in the case of an organization described in section 511(a)(2)(B),
to the exercise or performance of any purpose or function described in
section 501(c)(3)). For example, a college or university described in
section 501(c)(3) cannot use the NAICS 2-digit code for educational
services to identify all its separate unrelated trades or businesses,
and a qualified retirement plan described in section 401(a) cannot use
the NAICS 2-digit code for finance and insurance to identify all of its
unrelated trades or businesses.
(2) Codes only reported once. An organization will report each
NAICS 2-digit code only once. For example, a hospital organization that
operates several hospital facilities in a geographic area (or multiple
geographic areas), all of which include pharmacies that sell goods to
the general public, would include all the pharmacies under the NAICS 2-
digit code for retail trade, regardless of whether the hospital
organization keeps separate books and records for each pharmacy.
(3) Erroneous codes. Once an organization has identified a separate
unrelated trade or business using a particular NAICS 2-digit code, the
organization may not change the NAICS 2-digit code describing that
unrelated trade or business unless the organization can show that the
NAICS 2-digit code chosen was due to an unintentional error and that
another NAICS 2-digit code more accurately describes the trade or
business.
[[Page 23197]]
(c) Activities in the nature of investments--(1) In general. An
organization's activities in the nature of investments (investment
activities) are treated collectively as a separate unrelated trade or
business for purposes of section 512(a)(6)(A) and paragraph (a) of this
section. Except as provided in paragraphs (c)(6) and (c)(8) of this
section, an organization's investment activities are limited to its--
(i) Qualifying partnership interests (described in paragraph (c)(2)
of this section);
(ii) Qualifying S corporation interests (described in paragraph
(e)(2)(i) of this section); and
(iii) Debt-financed property or properties (within the meaning of
section 514).
(2) Qualifying partnership interests--(i) Directly-held partnership
interests. An interest in a partnership is a qualifying partnership
interest (QPI) if the exempt organization holds a direct interest in a
partnership (directly-held partnership interest) that meets the
requirements of either the de minimis test (described in paragraph
(c)(3) of this section) or the control test (described in paragraph
(c)(4) of this section).
(ii) Indirectly-held partnership interests. If an organization does
not control (within the meaning of paragraph (c)(4)(iii) of this
section) a partnership in which the organization holds a direct
interest but that directly-held partnership interest is not a QPI
because the organization holds more than 20 percent of the capital
interest, any partnership in which the organization holds an indirect
interest through the directly-held partnership interest (indirectly-
held partnership interest) may be a QPI if the indirectly-held
partnership interest meets the requirements of the de minimis test
(described in paragraph (c)(3) of this section) (look-through rule).
For example, if an organization directly holds 50 percent of the
capital interests of a partnership that it does not control and the
directly-held partnership holds 4 percent of the capital and profits
interests of lower-tier partnership A, and 10 percent of the capital
and profits interests of lower-tier partnership B, the organization may
aggregate its interest in lower-tier partnership A with its other QPIs
because the organization indirectly holds 2 percent of the capital and
profits interests of lower-tier partnership A (4 percent x 50 percent).
However, the organization may not aggregate its interest in lower-tier
partnership B with its QPIs because the organization indirectly holds 5
percent of the capital and profits interests of lower-tier partnership
B (10 percent x 50 percent), which does not meet the requirements of
the de minimis test.
(iii) Designation. An organization that has a partnership interest
meeting the requirements of paragraph (c)(2)(i) or (ii) of this section
in a taxable year may designate that partnership interest as a QPI by
including its share of partnership gross income (and directly connected
deductions) with the gross income (and directly connected deductions)
from its other investment activities (see paragraph (c)(1) of this
section) in accordance with forms and instructions. Any partnership
interest that is designated as a QPI remains a QPI unless and until it
no longer meets the requirements of paragraph (c)(2)(i) or (ii) of this
section. For example, if an organization designates a directly-held
partnership interest that meets the requirements of the de minimis rule
as a QPI in one taxable year, the organization cannot, in the next
taxable year, use NAICS 2-digit codes to describe the partnership
trades or businesses that are unrelated trades or businesses with
respect to the organization unless the directly-held partnership
interest fails to meet the requirements of both the de minimis test and
the control test.
(3) De minimis test. A partnership interest is a QPI that meets the
requirements of the de minimis test if the organization holds directly
(within the meaning of paragraph (c)(2)(i) of this section) or
indirectly (within the meaning of paragraph (c)(2)(ii) of this section)
no more than 2 percent of the profits interest and no more than 2
percent of the capital interest.
(4) Control test--(i) In general. A partnership interest is a QPI
that meets the requirements of the control test if the organization
holds no more than 20 percent of the capital interest and does not
control the partnership within the meaning of paragraph (c)(4)(iii) of
this section.
(ii) Combining related interests. When determining an
organization's percentage interest in a partnership for purposes of
paragraph (c)(4)(i) of this section, the interests of a supporting
organization (as defined in section 509(a)(3) and Sec. 1.509(a)-4) or
a controlled entity (as defined in section 512(b)(13)(D) and Sec.
1.512(a)-1(l)) in the same partnership will be taken into account. For
example, if an organization owns 10 percent of the capital interests in
a partnership, and its supporting organization owns an additional 15
percent capital interest in that partnership, the organization would
not meet the requirements of the control test because its aggregate
percentage interest exceeds 20 percent (10 percent + 15 percent = 25
percent).
(iii) Control. All facts and circumstances, including the
partnership agreement, are relevant for determining whether an
organization controls a partnership. In any case, however, an
organization controls a partnership if--
(A) The organization, by itself, may require the partnership to
perform, or may prevent the partnership from performing, any act that
significantly affects the operations of the partnership;
(B) Any of the organization's officers, directors, trustees, or
employees have rights to participate in the management of the
partnership at any time;
(C) Any of the organization's officers, directors, trustees, or
employees have rights to conduct the partnership's business at any
time; or
(D) The organization, by itself, has the power to appoint or remove
any of the partnership's officers or employees or a majority of
directors.
(5) Reliance on Schedule K-1 (Form 1065)--(i) In general. When
determining the organization's percentage interest (described in
paragraph (c)(5)(ii) of this section) in a partnership for purposes of
the de minimis test (described in paragraph (c)(3) of this section) and
the control test (described in paragraph (c)(4) of this section), an
organization may rely on the Schedule K-1 (Form 1065) (or its
successor) it receives from the partnership if the form lists the
organization's percentage profits interest or its percentage capital
interest, or both, at the beginning and end of the year. However, the
organization may not rely on the form to the extent that any
information about the organization's percentage interest is not
specifically provided. For example, if the Schedule K-1 (Form 1065) an
organization receives from a partnership lists the organization's
profits interest as ``variable'' but lists its percentage capital
interest at the beginning and end of the year, the organization may
rely on the form only with respect to its percentage capital interest.
(ii) Determining percentage interest. For purposes of paragraph
(c)(5)(i) of this section, an organization determines its percentage
interest by taking the average of the organization's percentage
interest at the beginning and the end of the partnership's taxable
year, or, in the case of a partnership interest held for less than a
year, the percentage interest held at the beginning and end of the
period of ownership within the partnership's taxable year. For example,
if an organization acquires an interest in a partnership that files on
a calendar year basis in May and the partnership
[[Page 23198]]
reports on Schedule K-1 (Form 1065) that the partner held a 3 percent
profits interest at the date of acquisition but held a 1 percent
profits interest at the end of the calendar year, the organization will
be considered to have held 2 percent of the profits interest in that
partnership for that year ((3 percent + 1 percent)/2).
(6) UBTI from the investment activities of organizations subject to
section 512(a)(3). For purposes of paragraph (c)(1) of this section,
UBTI from the investment activities of an organization subject to
section 512(a)(3) includes any amount that--
(i) would be excluded from the calculation of UBTI under section
512(b)(1), (2), (3), or (5) if the organization were subject to section
512(a)(1);
(ii) is attributable to income set aside (and not in excess of the
set aside limit described in section 512(a)(3)(E)), but not used, for a
purpose described in section 512(a)(3)(B)(i) or (ii); or
(iii) is in excess of the set aside limit described in section
512(a)(3)(E).
(7) Transition rule for certain partnership interests--(i) In
general. If a directly-held partnership interest acquired prior to
August 21, 2018, is not a QPI, an organization may treat such
partnership interest as a separate unrelated trade or business for
purposes of section 512(a)(6) regardless of the number of unrelated
trades or businesses directly or indirectly conducted by the
partnership. For example, if an organization has a 35 percent capital
interest in a partnership acquired prior to August 21, 2018, it can
treat the partnership as a single trade or business even if the
partnership's investments generated UBTI from lower-tier partnerships
that were engaged in multiple trades or businesses. A partnership
interest acquired prior to August 21, 2018, will continue to meet the
requirement of this rule even if the organization's percentage interest
in such partnership changes before the end of the transition period
(see paragraph (c)(7)(iii) of this section).
(ii) Exclusivity. An organization may apply either the transition
rule in paragraph (c)(7)(i) of this section or the look-through rule in
paragraph (c)(2)(ii) of this section, but not both, to a partnership
interest described in paragraph (c)(7)(i) of this section that also
qualifies for application of the look-through rule described in
paragraph (c)(2)(ii).
(iii) Transition period. An organization may rely on this
transition rule until the first day of the organization's first taxable
year beginning after [DATE OF PUBLICATION OF THE FINAL RULES IN THE
FEDERAL REGISTER].
(8) Limitations--(i) Social clubs. Paragraphs (c)(2) (regarding
QPIs) and (c)(7) (transition rule for certain partnership interests) of
this section do not apply to social clubs described in section
501(c)(7).
(ii) General partnership interests. Any partnership in which an
organization is a general partner is not a QPI within the meaning of
paragraph (c)(2) of this section, regardless of the organization's
percentage interest.
(iii) Application of other sections. This paragraph (c) will not
otherwise impact application of section 512(c) and the fragmentation
principle under section 513(c).
(d) Income from certain controlled entities--(1) Specified payments
from controlled entities. If an organization (controlling organization)
controls another entity (within the meaning of section 512(b)(13)(D))
(controlled entity), all specified payments (as defined in section
512(b)(13)(C)) received by a controlling organization from that
controlled entity will be treated as gross income from a separate
unrelated trade or business for purposes of paragraph (a) of this
section. If a controlling organization receives specified payments from
two different controlled entities, the payments from each controlled
entity are treated as a separate unrelated trade or business. For
example, a controlling organization that receives rental payments from
two controlled entities will have two separate unrelated trades or
businesses, one for each controlled entity. The specified payments from
a controlled entity will be treated as gross income from one trade or
business regardless of whether the controlled entity engages in more
than one unrelated trade or business or whether the controlling
organization receives more than one type of specified payment from that
controlled entity.
(2) Certain amounts derived from controlled foreign corporations.
All amounts included in UBTI under section 512(b)(17) will be treated
as income derived from a separate unrelated trade or business for
purposes of paragraph (a) of this section.
(e) S corporation interests--(1) In general. Except as provided in
paragraph (e)(2) of this section, if an organization owns stock in an S
corporation (S corporation interest), such S corporation interest will
be treated as an interest in a separate unrelated trade or business for
purposes of paragraph (a) of this section. Thus, if an organization
owns two S corporation interests, neither of which is described in
paragraph (e)(2) of this section, the exempt organization will report
two separate unrelated trades or businesses, one for each S corporation
interest. The UBTI from an S corporation interest is the amount
described in section 512(e)(1)(B).
(2) Exception--(i) Qualifying S corporation interest.
Notwithstanding paragraph (e)(1) of this section, an organization may
aggregate its UBTI from an S corporation interest with its UBTI from
other investment activities (described in paragraph (c)(1) of this
section) if the organization's ownership interest (by percentage of
stock ownership) in the S corporation meets the criteria for a QPI as
described in paragraph (c)(2)(i) of this section (qualifying S
corporation interest).
(ii) Reliance on Schedule K-1 (Form 1120-S). When determining how
much S corporation stock an organization owns for purposes of paragraph
(e)(2)(i) of this section, the organization may rely on the Schedule K-
1 (Form 1120-S) (or its successor) it receives from the S corporation
if the form lists the organization's percentage of stock ownership for
the year.
(f) Allocation of deductions. An organization must allocate
deductions between separate unrelated trades or businesses using the
method described in Sec. 1.512(a)-1(c).
(g) Total UBTI--(1) In general. The total UBTI of an organization
with more than one unrelated trade or business is the sum of the UBTI
computed with respect to each separate unrelated trade or business (as
identified under paragraph (a)(2) of this section and subject to the
limitation described in paragraph (g)(2) of this section), less a
specific deduction under section 512(b)(12).
(2) UBTI not less than zero. For purposes of paragraph (g)(1) of
this section, the UBTI with respect to any separate unrelated trade or
business identified under paragraph (a)(2) of this section cannot be
less than zero.
(h) Net operating losses--(1) In general. For taxable years
beginning after December 31, 2017, an exempt organization with more
than one unrelated trade or business determines the NOL deduction
allowed by sections 172(a) and 512(b)(6) separately with respect to
each of its unrelated trades or businesses. Accordingly, if an exempt
organization has more than one unrelated trade or business, Sec.
1.512(b)-1(e) applies separately with respect to each such unrelated
trade or business.
(2) Coordination of pre-2018 and post-2017 NOLs. An organization
with losses arising in a taxable year beginning before January 1, 2018
(pre-2018 NOLs),
[[Page 23199]]
and with losses arising in a taxable year beginning after December 31,
2017 (post-2017 NOLs), deducts its pre-2018 NOLs from total UBTI before
deducting any post-2017 NOLs with regard to a separate unrelated trade
or business against the UBTI from such trade or business. Pre-2018 NOLs
are taken against the total UBTI as determined under paragraph (g) of
this section in the manner that results in maximum utilization of the
pre-2018 NOLs in a taxable year.
(i) Applicability dates. This section is applicable to taxable
years beginning on or after [DATE OF PUBLICATION OF THE FINAL RULES IN
THE FEDERAL REGISTER].
0
Par. 6. Section 1.512(b)-1 is proposed to be amended by:
0
1. Revising paragraph (a)(1).
0
2. Adding a new sentence to the end of paragraph (a)(3).
0
3. Adding a new paragraph (e)(5).
0
4. Adding new paragraphs (g)(4) and (5).
The revisions and additions read as follows:
Sec. 1.512 (b)-1 Modifications
(a) * * *
(1) * * * Dividends (including an inclusion of subpart F income
under section 951(a)(1)(A) or an inclusion of global intangible low-
taxed income (GILTI) under section 951A(a), both of which are treated
in the same manner as a dividend for purposes of section 512(b)(1)),
interest, payments with respect to securities loans (as defined in
section 512(a)(5)), annuities, income from notional principal contracts
(as defined in Sec. 1.837-7 or regulations issued under section 446),
other substantially similar income from ordinary and routine
investments to the extent determined by the Commissioner, and all
deductions directly connected with any of the foregoing items of income
must be excluded in computing unrelated business taxable income.
* * * * *
(3) * * * The exclusion under paragraph (a)(1) of this section of
an inclusion of subpart F income under section 951(a)(1)(A) or an
inclusion of GILTI under section 951A(a) from income (both inclusions
being treated in the same manner as dividends) is applicable to taxable
years beginning on or after [DATE OF PUBLICATION OF THE FINAL RULES IN
THE FEDERAL REGISTER]. However, an organization may choose to apply
this exclusion to taxable years beginning before [DATE OF PUBLICATION
OF THE FINAL RULES IN THE FEDERAL REGISTER].
* * * * *
(e) * * *
(5) See Sec. 1.512(a)-6(h) regarding the computation of the net
operating loss deduction when an organization has more than one
unrelated trade or business.
* * * * *
(g) * * *
(4) The term unrelated business taxable income as used in section
512(b)(10) and (11) refers to unrelated business taxable income after
application of section 512(a)(6).
(5) Paragraph (g)(4) of this section is applicable to taxable years
beginning on or after [DATE OF PUBLICATION OF THE FINAL RULES IN THE
FEDERAL REGISTER].
* * * * *
0
Par. 7. Section 1.513-1 is proposed to be amended by:
0
1. Revising the third and fourth sentence in paragraph (a).
0
2. Redesignating paragraphs (f) and (g) as paragraphs (g) and (h).
0
3. Adding new paragraph (f).
0
4. Adding a new sentence to the end of new paragraph (h).
The revisions and additions read as follows:
Sec. 1.513-1 Definition of unrelated trade or business.
(a) * * * For certain exceptions from this definition, see
paragraph (e) of this section. For a special definition of unrelated
trade or business applicable to certain trusts, see paragraph (f) of
this section. * * *
* * * * *
(f) Special definition of ``unrelated trade or business'' for
trusts. In the case of a trust computing its unrelated business taxable
income under section 512 for purposes of section 681, or a trust
described in section 401(a) or section 501(c)(17), which is exempt from
tax under section 501(a), section 513(b) provides that the term
unrelated trade or business means any trade or business regularly
carried on by such trust or by a partnership of which it is a member.
This definition also applies to an individual retirement account
described in section 408 that, under section 408(e), is subject to the
tax imposed by section 511.
* * * * *
(h) * * * Paragraph (f) of this section applies to taxable years
beginning on or after [DATE OF PUBLICATION OF THE FINAL RULES IN THE
FEDERAL REGISTER].
* * * * *
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2020-06604 Filed 4-23-20; 8:45 am]
BILLING CODE 4830-01-P
