Long-Awaited UBTI Proposed Regulations Released

| 4/30/2020
Long-Awaited UBTI Proposed Regulations Released

On April 23, the U.S. Department of the Treasury and the IRS issued proposed regulations under Section 512(a)(6), which was enacted by the Tax Cuts and Jobs Acts of 2017. Section 512(a)(6) requires tax-exempt organizations to calculate unrelated business taxable income (UBTI) separately with respect to each trade or business. Section 512(a)(6) also provides that losses from one unrelated trade or business cannot offset the gains from another. Comments on the proposed regulations are due by June 23, 2020.

The proposed regulations expand on interim guidance and transition rules provided in Notice 2018-67, which was issued on Aug. 21, 2018. Following are highlights of the proposed regulations:

Trade or business determination. An exempt organization must identify its separate unrelated business trades or businesses using the first two digits of the North American Industry Classification System (NAICS) codes (which would identify trades or businesses in 20 sectors) rather than by the six-digit NAICS codes as provided in the notice. This change is significant and is intended to minimize implementation costs and mitigate the administrative burden on exempt organizations. 

Investment activities. The investment activities that can be treated as one separate unrelated trade or business are limited to:

  • Qualifying partnership interests (QPIs)
  • Debt-financed properties
  • Qualifying S-corporation interests

A partnership interest is a QPI if it meets the requirements of either the de minimis test or the control test. 

  • Generally, a partnership interest meets the de minimis test if the exempt organization directly holds no more than 2% of the profits interest and no more than 2% of the capital interest. Unlike the notice, the proposed regulations do not require that related interests be combined to determine if the de minimis test is met. Additionally, exempt organizations are permitted to aggregate any indirectly held partnership interests that meet the requirements of the de minimis test with all other QPIs (look-through rule). 
  • Generally, a partnership interest meets the control test if the exempt organization holds no more than 20% of the capital interest and does not control the partnership. All the facts and circumstances are relevant for determining whether an exempt organization controls a partnership, including the partnership agreement. 

Transition rule. An exempt organization is permitted to treat as one trade or business each partnership interest acquired prior to Aug. 21, 2018, that failed to meet the de minimis test or the control test. This transition rule may be relied on only until the first day of the organization’s first taxable year beginning after the date regulations are published as final. Exempt organizations may apply either the transition rule or the look-through rule, but not both, to a partnership interest.

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Debt-financed income. Because debt-financed properties generally are held for investment purposes, the proposed regulations include all the UBTI from an exempt organization’s debt-financed properties (not just its unrelated debt-financed income arising in connection with a QPI) in the list of investment activities treated as a separate unrelated trade or business. However, this treatment generally does not extend to rental activities.

Expense allocation. The proposed regulations state that separate guidance will address expense allocation. However, the proposed regulations provide that an unadjusted gross-to-gross method is not a reasonable allocation method because it does not achieve a proper ratio of the per-unit price of related activities to unrelated activities.

Specified payments from controlled entities. An exempt organization is permitted 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.

S-corporation interests. Each S-corporation interest will be treated as an interest in a separate unrelated trade or business, which includes the items of income, loss, or deduction and the gain and loss on the disposition of S-corporation stock. An exempt organization may aggregate its UBTI from an S-corporation interest with its UBTI from other investment activities if its stock ownership percentage meets the de minimis test or the control test. 

Charitable contribution deduction. Charitable contribution deductions may be taken against total UBTI rather than being allocated among unrelated trades or businesses. 

Net operating loss (NOL) deduction. An exempt organization with both pre-2018 and post-2017 NOLs should deduct its pre-2018 NOLs from its total before deducting any post-2017 NOLs. Pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum use of the pre-2018 NOLs in a taxable year. The proposed regulations do not address the impact of the Coronavirus Aid, Relief, and Economic Security Act on the calculation of UBTI. 

Subpart F income and global intangible low-taxed income (GILTI). An inclusion of Subpart F income under Section 951, and of GILTI under Section 951A, is treated the same as a dividend for purposes of Section 512(b)(1).

Public support. Because Section 512(a)(6) potentially affects the public support test, organizations with more than one unrelated trade or business are permitted to aggregate net income and losses from all unrelated business activities for purposes of determining whether the organization is publicly supported.

Other. Special rules pertain to social clubs, voluntary employees’ beneficiary associations, and supplemental unemployment compensation benefits trusts. 

Reliance. For tax years beginning before the date the regulations are published as final, exempt organizations identifying separate unrelated trades or businesses may rely on a reasonable, good faith interpretation of Sections 511-514 (considering all the facts and circumstances), on the proposed regulations in their entirety, or on Notice 2018-67.

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Janice Smith
Janice Smith
Managing Director