IRS Issues Guidance for New UBTI “Siloing” Rules under Section 512(a)(6)
Tax-Exempt Organizations Alert 08/29/18 Patricia A. Hintz, Cathleen T. Yu
On August 21, 2018, the IRS released an advance version of Notice 2018-67 (the Notice), containing guidance regarding the new unrelated business taxable income (UBTI) “siloing” provision under section 512(a)(6) of the Internal Revenue Code. The Notice can be viewed in its entirety here.
Section 512(a)(6) was enacted by the Tax Cuts and Jobs Act (the Act) in December 2017 and requires an exempt organization subject to the unrelated business income tax under section 511 of the Code, that has more than one unrelated trade or business to calculate UBTI separately with respect to each trade or business. The new requirement has created significant uncertainty in the exempt organizations community, in no small part because, as recognized in the Notice, “Congress did not provide 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.”
Among other things, the Notice provides interim reliance on a reasonable, good-faith standard for identifying separate trades or businesses; provides interim and transition rules for aggregating income from certain investment partnerships and debt-financed income from such partnerships; discusses the application of section 512(a)(6) to certain special types of income and organizations (e.g., social clubs); provides information on how to calculate net operating losses (NOLs) within section 512(a)(6); and provides guidance on the treatment of global intangible low-taxed income (GILTI) under new section 951A for purposes of the unrelated business income tax under section 511.
Pending the issuance of proposed regulations on these issues, the provisions of the Notice generally may be relied upon by taxpayers for taxable years beginning after December 31, 2017, as discussed in more detail below.
Identifying Separate Trades or Businesses
The Notice provides that, pending issuance of proposed regulations, exempt organizations may rely on 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 of section 512(a)(6). Specifically, a “reasonable, good-faith interpretation” includes the use of the North American Industry Classification System (NAICS) 6-digit codes. The NAICS is an industry classification system for collecting, analyzing, and publishing statistical data related to the U.S. business economy. Exempt organizations that already file Form 990-T to report UBTI are required to use the 6-digit NAICS codes when describing the organization’s unrelated trades or businesses.
The Notice also provides that the fragmentation principle in section 513(c) (and related guidance) may also provide helpful guidance. In general, the fragmentation principle primarily is used to separate unrelated trades or businesses from exempt activities.
Investment Activities and Partnership Investments
One of the primary questions concerning new section 512(a)(6) was whether it requires an exempt organization to “silo” UBTI according to the underlying trades or businesses conducted directly or indirectly by investment partnerships in which an exempt organization is an investor. For example, an exempt organization may be invested in a private equity fund that itself is invested in operating businesses conducting various trades or businesses. In many cases, the exempt organization is a passive investor in the private equity fund and may not have sufficient information from the fund to determine which portion of the flow-through UBTI was attributable to which separate business.
Thankfully, the Notice recognizes the potential administrative burden (both for taxpayers and the IRS) of requiring an exempt organization to calculate UBTI separately with respect to each unrelated trade or business carried on by a partnership in which the organization is a direct or indirect partner. Accordingly, the Notice provides that the Treasury and the IRS intend to issue proposed regulations treating certain activities “in the nature of investment” of an exempt organization as one trade or business for purposes of section 512(a)(6) in order to permit exempt organizations to aggregate gross income and directly connected deductions from all such investment activities.
Pending the issuance of those proposed regulations, the Notice also provided more specific interim and transitional guidance with respect to aggregating UBTI from an exempt organization’s interest in certain investment partnerships:
Interim Rule. An exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly-held interest in the partnership meets the requirements of either (1) a de minimis test or (2) a control test (each such directly held partnership that meets one of the tests, “qualifying partnership”). Additionally, under this rule, an exempt organization may aggregate all qualifying partnership interests and treat the aggregate group of qualifying partnerships as comprising a single trade or business for purposes of section 512(a)(6).
De minimis test. A partnership interest is a qualifying partnership interest that meets the de minimis test if the exempt organization holds no more than 2 percent of the profits interest and no more than 2 percent of the capital interest of the partnership, each as shown in Part II, line J of the Schedule K-1 received by the exempt organization (or the average of the profits interest and capital interest as of the beginning and the end of the partnership’s taxable year).
Control test. A partnership interest is a qualifying partnership that meets the control test if the exempt organization (a) directly holds no more than 20 percent of the capital interest (also according to Part II, line J of the Schedule K-1) and (b) does not have “control or influence” over the partnership. All facts and circumstances are relevant for purposes of determining “control or influence”, but an organization will have control or influence if either:
- it may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership; or
- any of its officers, directors, trustees, or employees have a right to participate in the management of the partnership or conduct the partnership’s business at any time, or if the exempt organization has the power to appoint or remove any of the partnership’s officers, directors, trustees, or employees.
Combining Related Interest. When determining an exempt organization’s interest in a partnership for both the de minimis test and the control test, the interests of a disqualified person with respect to the exempt organization, a supporting organization of the exempt organization, or a controlled entity with respect to the exempt organization will be taken into account.
Transition Rule. For partnership interests acquired before August 21, 2018, with respect to which an exempt organization is not applying the Interim Rule, the exempt organization may treat each partnership interest as comprising a single trade or business for the purposes of section 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnership, and whether or not the interest meets the de minimis test or the control test. However, the Transition Rule does not treat the aggregate group of partnership interests acquired before August 21, 2018, as comprising a single trade or business for purposes of section 512(a)(6) if the partnerships do not meet either the de minimis test or the control test.
Regardless of whether a partnership is a “qualifying partnership” under the Interim Rule, an exempt organization may use NOL deductions from NOL carry forwards arising from tax years beginning before January 1, 2018 (pre-2018 NOLs) to reduce total UBTI, pursuant to a special transition rule under the Act. Thus, the inability to aggregate UBTI from multiple partnerships may not have an impact on an exempt organization’s tax liability until such pre-2018 NOLs have been depleted.
The Notice also provides that the income from qualifying partnerships permitted to be aggregated per the Interim Rule or the Transition Rule includes any unrelated debt-financed income that arises in connection with the qualifying partnership interests.
- The Notice also addresses the treatment of items of UBTI under sections 512(b)(4) (unrelated debt-financed income), 512(b)(13) (certain income from controlled entities), and 512(b)(17) (certain insurance income) for purposes of section 512(a)(6). The Notice provides that the Treasury and the IRS generally do not see a distinction between these items included in UBTI and income derived by any exempt organization from an unrelated trade or business regularly carried on by it under section 512(a)(1), but recognize that aggregating income included in UBTI under sections 512(b)(4), (13), and (17) may be appropriate in certain cases.
- The Notice provides that any amount treated as UBTI under new section 512(a)(7) (relating to certain qualified transportation fringe benefits) is not subject to section 512(a)(6).
- The Notice provides that the Treasury and the IRS have determined that an inclusion of GILTI under section 951A(a) is to be treated as a dividend and therefore generally excluded from UBTI under section 512(b)(1) (similar to subpart F income under section 951(a)).
- The Notice provides that section 512(a)(6) generally applies to an organization described in section 512(a)(3) (i.e., social clubs, VEBAs, and supplementary unemployment compensation benefit trusts) if the organization has more than one unrelated trade or business, even though section 512(a)(3) uses different terminology than does section 512(a)(1) (defining “unrelated business taxable income”). For example, section 512(a)(6) would apply to a social club that receives non-member income from multiple sources, such as a dining facility and a retail store. Also, the Interim Rule and the Transition Rule do not apply to social clubs described in section 501(c)(7) that are subject to section 512(a)(3).
- The Notice recognizes certain ambiguities in the interpretation of amended section 172 with respect to the limitation of post-2017 NOLs in the context of 512(a)(6). The Treasury and the IRS intend to issue proposed regulations addressing these issues and request comments on how the NOL deduction should be taken under section 512(a)(6) by exempt organizations with more than one trade or business and, in particular, by organizations with both pre-2018 and post-2017 NOLs.
Quarles & Brady Comment
The Notice generally should be viewed as welcome guidance for the exempt organizations community, particularly those organizations with significant alternative investment portfolios. Such organizations likely would benefit from a review of their existing investment partnerships to determine whether the interests satisfy either the de minimis or control tests and, if not, what impact siloing each individual investment may have on the organization’s overall UBTI. Further, the composition of an exempt organization’s existing investment portfolio, the organization’s profit interest and capital interest in and control over investment partnerships, and the effects of the “siloing” provision under section 512(a)(6) (as interpreted by the Notice and future proposed regulations) will inform future investment decisions on the optimal choice of vehicle (i.e., whether to invest in a vehicle taxed as a corporation or a vehicle taxed as a partnership for U.S. federal income tax purposes).
The Notice likely will prove helpful to many organizations in determining their UBTI under new section 512(a)(6), though of course questions remain. For example:
- Does an organization’s ability to appoint a representative to an investor committee or other advisory body with respect to an investment partnership constitute such organization’s “participation” in the management of the partnership for purposes of the Control Test?
- Should exceptions be made for the first year of an organization’s investment in a partnership, when the organization’s percentage interest may exceed either the 2 percent or 20 percent thresholds (i.e., before additional investors have made investments)?
- To what extent must an exempt organization seek information on underlying trades or businesses from investment partnerships, and what happens if the exempt organization is unable to obtain sufficient information?
- If the NAICS codes are adopted as a reasonable method of identifying separate trades or businesses, must an exempt organization use the self-selected NAICS code of an underlying investment’s trade or business, or may it select a different code (including a broader 3-, 4- or 5-digit code)?
- What does it mean that fringe benefit UBTI inclusions are “not subject” to section 512(a)(6)? Is such UBTI inclusion a de facto silo, or may unrelated trade or business losses be applied against fringe benefit UBTI?
The attorneys in the Tax-Exempt Organizations Group at Quarles & Brady regularly advise exempt organizations on complex UBTI matters, including reviewing investments in partnerships and other alternative investments generating UBTI impacted by the Notice. We would be pleased to talk with you about your questions.