With some exceptions, organizations subject to the unrelated business income tax under Section 511 that have more than one unrelated trade or business may rely on a “reasonable, good-faith interpretation of §§ 511 through 514” when identifying different trades or businesses for purposes of the new silo rules under Section 512(a)(6) pending issuance of proposed regulations. The Internal Revenue Service (IRS) has identified use of the North American Industry Classification System as a “reasonable, good-faith interpretation.” The IRS is requesting comments on how to set forth an administrable method for identifying separate trades or businesses for purposes of the new rules that will not significantly increase the administrative burden on organizations in complying with the new rules or on the IRS in implementing and enforcing the new rules.

Background

Under Section 511(a)(1) of the Internal Revenue Code (Code), tax-exempt organizations are generally subject to tax on unrelated business taxable income (UBTI) from unrelated trades or businesses that carried on regularly. An “unrelated trade or business” is any trade or business the conduct of which is not substantially related to the exercise or performance of such organization’s tax-exempt purposes.

Prior to the enactment of the act formerly known as the “Tax Cuts and Jobs Act,” tax-exempt organizations with unrelated business activity were treated similarly to taxable corporations and permitted to aggregate gross income and deductions from all unrelated business activities without consideration of whether some business activities constituted a separate trade or business. The act added Section 512(a)(6) to the Code and removed this parity. Section 512(a)(6) requires tax-exempt organizations to calculate UBTI separately for each trade or business. Unlike taxable corporations, tax-exempt organizations can no longer aggregate gross income and deductions from unrelated trades or business and pay tax only on their aggregate net income.

Notice 2018-67

In enacting Section 512(a)(6), 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. There is no general statutory or regulatory definition of what constitutes a “trade or business” for purposes of the Code. Acknowledging the potential administrative burden to tax-exempt organizations affected by Section 512(a)(6) and to the IRS in administering the new law, and the challenge in determining what constitutes separate trades or businesses, Notice 2018-67 issued August 21, 2018 (the Notice), provides interim guidance and transition rules for applying the new law. The Notice also requests comments regarding rules to identify separate trades or businesses that will be administrable for tax-exempt organizations and the IRS.

“Reasonable, Good-Faith Interpretation” Standard

The Notice provides that exempt organizations generally may rely on a “reasonable, good-faith interpretation” of Sections 511–514 when identifying separate trades or businesses and calculating UBTI for purposes of Section 512(a)(6) until regulations are proposed. The Notice identifies the use of North American Industry Classification System (NAICS) six-digit codes as a “reasonable, good-faith interpretation” for identifying separate trades or businesses. It also points to the “fragmentation principle” under Section 513(c) as a possible source of helpful guidance. The fragmentation principle provides that an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may or may not be related to an organization’s tax-exempt purposes (for example, the regular sale of pharmaceuticals to the general public by a hospital pharmacy that also furnishes supplies to the hospital and its patients).

The Notice also identifies Code sections that the US Treasury Department and the IRS do not view as useful for purposes of Section 512(a)(6). These include Section 132 (certain fringe benefits), Section 162 (trade or business expenses), Section 183 (activities not engaged in for profit), Section 414 (definitions and special rules related to certain deferred compensation and other arrangements), and Section 469 (passive activity losses and credits). Nonetheless, the Treasury Department and the IRS are requesting comments describing whether and how these and other Code sections, as well as the NAICS codes, may aid in determining how to identify an exempt organization’s separate trades or businesses for purposes of Section 512(a)(6).

The “reasonable, good-faith interpretation” standard applies equally to determining whether to separate unrelated debt-financed income, specified payments received from controlled entities, and certain insurance income that is treated as gross income derived from an unrelated trade or business under Sections 512(b)(4), (13), and (17), respectively, that is included in the calculation of UBTI.

“Investment Activities” Treated as a Single Trade or Business

The Notice provides special interim guidance for investments in partnerships. The activities of a partnership are generally considered the activities of the partners. An exempt organization that is a partner in a partnership that conducts an unrelated trade or business with respect to the exempt organization is required to include in UBTI its distributive share of gross partnership income (and directly connected partnership deductions) from such unrelated trade or business. This raises the question of whether an exempt organization must calculate UBTI separately with respect to each unrelated trade or business carried on by a partnership in which the organization is a partner (either directly or indirectly). This could create a significant administrative burden to an exempt organization holding partnership interests, particularly in multi-tier partnership structures. 

The Treasury Department and the IRS intend to propose regulations treating certain activities in the nature of an investment as one trade or business for purposes of Section 512(a)(6)(A) to permit exempt organizations to aggregate gross income and directly connected deductions from such “investment activities.” The Treasury Department and the IRS request comments regarding the scope of the activities, both investment partnership interests or other activities in the nature of an investment that may generate unrelated business income, that should be included in the category of “investment activities” for purposes of Section 512(a)(6). In the meantime, the Notice provides special interim and transition rules for partnership investments.

“Qualifying Partnership Interests” May Be Aggregated

The Notice provides that, pending proposed regulations, exempt organizations (other than those described in Section 501(c)(7)) may aggregate all “Qualifying Partnership Interests” and treat them as single trade or business for purposes of calculating UBTI. A partnership interest, including an interest in a single partnership with multiple trades or business conducted directly or through lower-tier partnerships, is a “Qualifying Partnership Interest” if it meets either the “de minimis test” or the “control test.”

De minimis test. A partnership interest generally meets the de minimis test if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership.

Control test. A partnership interest generally meets the requirements of the control test if the exempt organization (i) directly holds no more than 20% of the capital interest in the partnership; and (ii) does not have control or influence over the partnership.

When calculating its percentage interests for both the de minimis and the control tests, an exempt organization must include the interests of a disqualified person, supporting organization, or controlled entity in the same partnership. For partnership interests acquired prior to August 21, 2018, that do not meet either test, organizations may treat each partnership interest as a single trade or business for purposes of Section 512(a)(6) regardless of whether there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships.

Most interests in typical pooled investment funds can be treated as a single trade or business so long as the organization has no more than a 20% interest and does not have control or influence over the partnership. Control or influence includes the ability to (i) require or prevent taking any significant operational actions, (ii) participation in the management, or (iii) appoint or remove any officers or managers of the fund.

Additional Guidance

In addition to the guidance discussed above, the Notice also provides that

• the Treasury Department and IRS do not believe the provision of fringe benefits described in Section 512(a)(7) is an unrelated trade or business and, as such, any amount subject to UBIT under Section 512(a)(7) is not subject to the silo rules of Section 512(a)(6); and
• an inclusion of global intangible low-taxed income (GILTI) under new Section 951(A) (requiring each US shareholder of a controlled foreign corporation to include any GILTI in gross income) by a tax-exempt organization will be treated as a dividend and therefore generally excluded from UBTI.

Practical Considerations

Tax-exempt organizations that engage in one or more unrelated trades or business may be subject to significant increased administrative burden as a result of Section 512(a)(6). To reduce this burden and to restore the prior parity with taxable corporations, certain tax-exempt organizations may consider transferring their unrelated trades or businesses into a taxable subsidiary. Private foundations are restricted from having excess business holdings, but other tax-exempt organizations may be able to achieve administrative efficiencies and cost savings with such restructuring.

Tax-exempt entities that anticipate earning income from more than one unrelated trade or business or that otherwise may be impacted by the Notice should consider providing comments on the guidance contained in the Notice to the Treasury Department and the IRS. Comments must be submitted by December 3, 2018.