The new “siloing” law requiring computing UBI separately for each unrelated business created significant challenges. Notice 2018-67, released last fall, addressed some of these questions. The Notice’s interim guidance can be relied on until formal regulations are adopted. The Notice requested comments, most notably whether NAICS codes should be used to determine the separate trades or businesses, how to treat activities that are not trades or businesses but statutorily included in unrelated business income (UBI), and how to treat partnership income where the partnership has multiple businesses.
Comments were submitted by various organizations such as the American Bar Association, TEGE Exempt Organization Council, National Council on Nonprofits, CPA firms, and some universities. We have read many of these (not all) and found interesting similarities in the suggestions.
Use of NAICS Codes
In separating the business lines, Notice 2018-67 recommends using a “reasonable, good-faith interpretation” considering all facts and circumstances, including using the North American Industry Classification System (NAICS) six digit codes. The NAICS is an industry classification system used for statistical purposes. NAICS is a two through six-digit hierarchical classification system, offering five levels of detail. Each digit in the code is part of progressively narrower categories, and more digits in the code signify greater classification detail. The first two digits designate the economic sector, the third digit designates the subsector, the fourth digit designates the industry group, the fifth digit designates the NAICS industry, and the sixth digit designates the national industry. Under Notice 2018-67, use of the six-digit codes will be considered a reasonable, good-faith interpretation.
Among the comments we read, we noticed overwhelming rejection of the reliance on full six-digit NAICS codes to identify separate trade or business activities. The NAICS codes were not designed for tax reporting and not well suited for the task. The codes were designed to identify purposes of organizations, not their specific activities. They can sometimes be too broad and sometimes too narrow. For example, one activity, such as event rental, could span four different codes – catering, parking, personal property rentals, and real estate rental. Must all these parts be separate trades or businesses? The code for leasing nonresidential buildings could include renting space for events, commercial business rentals, and hotel accommodations. Can all these be aggregated?
Many comments recommended using a two-digit classification. A few recommended three or four. A two-digit code would provide a safe harbor for smaller organizations, or at least be a factor in a facts and circumstances test. Most of these comments recommended that facts and circumstances be considered in conjunction with the two-digit NAICS classification. Some factors would include:
- Causal connection to the unrelated revenue
- Management structure – is there common control over the activities?
- Geographic location
- Interdependence among the activities. Do they involve the same products or services? Are the products or services usually provided together? Is the customer base the same? Do the activities involve common planning and coordination? Are they treated as a single unit for accounting purposes?
This less stringent approach would lessen the administrative burden of organizations that faced a record-keeping nightmare in separating activities usually operated together and in cost allocations. It should also increase consistency across all exempt organizations yet allow for variations in organizational operations.
Income from an Activity that is not a Trade or Business but Statutorily Included in UBI
Most of the commenters recommend exempting activities that are not trades or businesses from this rule. These include:
- Rents, interest, royalties, and annuities from controlled entities (512(b)(13))
- Qualified transportation fringe benefits (512(a)(7))
- Debt financed income (512(b)(4))
- Certain rents (512(b)(3)(B))
- Subpart F insurance income (512(b)(17))
- Partnership income where there is no control (512(c))
They suggest aggregating these together.
Many organizations hold investments in limited partnerships or LLCs in which the exempt organizations are limited partners and have no control. LLCs and partnerships are flow-through entities, and the income to the partner or LLC member retains its character. If the income in the partnership or LLC is derived from a business that would be unrelated to the exempt partner or member, that share of income retains that unrelated business income character. (For ease of reading we will use the term “partner” to include LLC members and “partnership” to include LLCs.) The partnership provides to its partners a Schedule K-1 each year that reports each partner’s allocable share of income and losses from the partnerships, including any exempt partner’s share of income that is UBI. Usually, not all the partnership income is UBI, and the UBI may come from multiple unrelated trades or businesses. Separating this income would be an administrative burden. The Notice provides an “Interim” rule that allows the exempt partner to treat its interest as one trade or business rather than multiple businesses. The organization also can aggregate multiple partnerships if it meets either a de minimis test or control test.
The exempt organization’s partnership interest meets the De Minimis Test if the interest is no more than 2% of the profits interest and no more than 2% of the capital interest. The Notice provides that an exempt organization’s 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 or influence over the partnership.
Both tests require combining the ownership interests of disqualified persons, supporting organizations, and controlled entities to determine if the thresholds are met. Some of the commenters recommend that all limited partnerships or LLCs (as a nonmanaging member) be a single activity regardless of the percentage of ownership. They also suggest raising the thresholds to 50% for the control test and 5% to 10% for the de minimis test. Some recommend there be no attribution of related party’s holdings.
We are eager to see what recommendations are adopted by the Treasury and what the regulations will say. Meanwhile, please contact your tax advisor for help in finding a reasonable, good-faith way to “silo” your unrelated trades and businesses.
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