After a long wait, the IRS finally issued proposed regulations on the unrelated business taxable income (UBTI) “siloing” rules on April 24, 2020.
These rules, under section 512(a)(6) of the Internal Revenue Code, require separately computing UBTI for multiple unrelated businesses. Thus, one cannot use a loss from one unrelated business to offset the taxable income of another unrelated business.
Here are the highlights:
Use of NAICS Codes
The proposed regulations allow the use of only the first two digits of the NAICS codes, along with considering all the facts and circumstances, to identify separate unrelated businesses. Currently, there are twenty of these two-digit NAICS codes to choose from, and organizations should choose the code that best reflects the actual unrelated business as opposed to the overall organization’s exempt purpose. Treasury stepped back from its recommendation of using the six-digit NAICS codes in response to comments on Notice 2018-67. The proposed regulations also specify that once one NAICS code has been used for an unrelated business, it cannot be changed unless it was chosen unintentionally in error and the new code more accurately describes the business.
Allocation of Expenses
Exempt organizations with unrelated businesses are already familiar with allocating deductible, indirect expenses between exempt activities and unrelated business activities. Under these siloing rules, they must also now further allocate these indirect expenses between the separate unrelated businesses. The proposed regulations keep the reasonable method standard but exclude as reasonable the unadjusted gross-to-gross revenue method.
Often fees for goods or services sold in an exempt activity are lower than fees for the same goods or services provided in an unrelated business. For example, a school may charge less for students’ use of the swimming pool than it charges the general public. Therefore, using an unadjusted gross-to-gross revenue method would skew expenses toward the unrelated business. The IRS plans to issue a separate notice of proposed rulemaking on the reasonable allocation issue.
Organizations may treat certain investment activities as one unrelated trade or business. Under the proposed regulations, qualified partnership interests, debt-financed property, and qualifying S corporation interests, may be treated collectively as one separate unrelated trade or business. All other investment activities would need to be reported as a separate unrelated trade or business.
A. Qualifying Partnership Interests
Many organizations hold investments in limited partnerships or LLCs. These are pass-through entities whereby the activity of the entity passes through to the partner or LLC member as if the partner or LLC member conducted the activity directly. (For ease of reading, we will use the term “partner” to include LLC members and “partnership” to include LLCs.) Therefore, if the activity of the partnership is from a business that would be unrelated to the exempt partner, that activity retains its unrelated business character to the exempt partner.
Separating each type of business within each partnership would be administratively burdensome to any organization. The proposed regulations allow, but do not require, the exempt partner to treat its qualified partnership interests (QPI) as one business rather than multiple businesses if it meets either a de minimis test or control test.
To meet the De Minimis Test, the exempt organization must hold no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership. There is also a look-through rule for applying the de minimis test to lower-tier partnerships whereby the exempt organization may combine indirectly held QPIs with directly held QPIs.
A partnership interest meets the Control Test if the exempt organization (i) directly holds no more than 20% of the capital interest of the partnership; and (ii) does not have control over the partnership. All the facts and circumstances are relevant in determining whether there is control.
Only the control test, and not the de minimis test, requires combining the ownership interests of supporting organizations and controlled entities to determine if the ownership percentage thresholds are met.
Prior to the issuance of the proposed regulations, Notice 2018-67 provided a transition rule whereby partnership interests acquired before August 21, 2018 that fail to meet either the de minimis test or control test may be treated as one business, even if the exempt organization’s percentage interest changes on or after this date. An exempt organization may continue to rely on this transition rule only until the final regulations are published.
B. Debt Financed Properties
Debt-financed properties that generate income such as rents, interest, royalties, or capital gains are generally held for investment purposes. Therefore, all the UBI from debt-financed properties, and not just its unrelated debt-financed income arising in connection with a QPI, is treated as one separate unrelated business under IRC section 512(a)(6).
C. Qualified S Corporation Interests
Following similar rules as the qualified partnership interest rules, if an exempt organization’s S corporation interests meet the QPI de minimis test or control test, it may aggregate its activity from all qualified S corporation interests with activity from other investment activities.
D. Controlled Entities
Interest, rent, royalty, or annuity payments received from a controlled entity, defined in IRC section 512(b)(13), may be aggregated as a single, separate unrelated business. This is regardless of whether the controlled entity engages in more than one unrelated business or whether the controlling organization receives more than one type of payment from that controlled entity. However, if a controlling organization receives such payments from two controlled entities, the payments from each controlled entity are treated as separate unrelated businesses.
Public Support Test
These siloing rules only apply in preparing the Form 990-T. They do not apply in determining whether an organization meets the public support test. Therefore, when reporting the unrelated business activity in Parts II or III of Schedule A of the Form 990, all unrelated business activities may be aggregated.
The IRS and Treasury are working on issuing final regulations by the end of October 2020. Until then, organizations may rely on Notice 2018-67, the proposed regulations, or a reasonable and good-faith interpretation of the siloing rules under section 512(a)(6). The IRS may issue further guidance on coordinating the siloing rules with the recent CARES Act. So, stay tuned.
To assist our clients and readers with navigating the complex new UBTI rules, we’ve created a series of flowcharts you can reference. If you have further questions, please contact your tax advisor or a Clark Nuber professional for help.
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