On April 24, 2020, the U.S. Treasury Department and Internal Revenue Service issued proposed regulations with respect to Section 512(a)(6) of the Internal Revenue Code. These regulations are designed to provide guidance on how an exempt organization determines if it has more than one unrelated trade or business, and if so, how the exempt organization calculates UBTI. These proposed regulations implement new section 512(a)(6) added by the Tax Cuts and Jobs Act, signed into law on December 22, 2017 (the TCJA). This section requires UBTI to be calculated separately for each trade or business. With respect to exempt organizations that invest through private equity funds, the regulations provide clarity on the aggregation rule that allows certain investment activities to be grouped together for UBTI purposes.
“Siloing” of Various Trades or Businesses for UBTI
Before the enactment of the TCJA, exempt organizations could aggregate income and loss from multiple UBTI activities. For example, if an exempt organization owned an interest in an LLC (taxed as a partnership) that produced net profits, and owned an interest in another LLC (taxed as a partnership) that produced a loss, so long as the exempt organization could prove a profit motive for the investments, the profit and loss would have been aggregated for UBTI purposes, resulting in a reduction or elimination in UBTI to the extent of the losses. However, upon enactment of the TCJA, exempt organizations are no longer allowed to aggregate the income and losses from multiple sources of UBTI. Instead, new Section 512(a)(6) requires that exempt organizations with more than one unrelated trade or business compute their income and loss separately for each trade or business, with no offset for losses of a separate trade or business.
The proposed regulations provide relief, however, for tax-exempts that invest through partnerships to earn investment income. In the absence of the proposed regulations, each separate trade or business conducted by each separate entity in which the tax-exempt invests would need to be segregated and taxed under the UBTI rules, without netting income and losses across the various trades or business. The impact of these rules are positive for tax-exempts that invest through partnerships, as now income and loss across various trades or businesses that a fund may invest in can be netted to produce an economically accurate UBTI inclusion, so long as certain ownership and control tests are met.
As an example, assume ExemptCo, an entity that has been granted Section 501(c)(3) status, invests in LLC 1, obtaining a 1.5 percent interest. If LLC 1, by virtue of its own investments in pass-through entities, is treated as engaged in multiple trades or businesses, then ExemptCo would be able to aggregate the income and losses of the trades or businesses it is deemed to be engaged in by virtue of its 1.5 percent interest in LLC 1. Accordingly, if LLC 1 were to invest in a partnership that owns and rents out an office building at a loss of approximately $100, as well as a partnership that operates a food and beverage distribution service that earns net income of $120, ExemptCo would aggregate the two businesses as one investment activity, and recognize only its pro rata share of the net $20 of UBTI. This is substantially more beneficial than the normal segregation scenario, in which ExemptCo would instead recognize its pro rata share of the $120 of UBTI from the food and beverage distribution business, and its pro rata share of the $100 loss from the office rental business that would be subject to the post-TCJA changes to net operating losses. Note that to use this rule, ExemptCo’s investment must meet a de minimis test. To satisfy the de minimis test, ExemptCo must hold no more than 2 percent of the profits interest and no more than 2 percent of the capital interest in LLC1. Alternatively, if ExemptCo’s investment in LLC 1 were greater than 2 percent of either the capital interest or profits interest, ExemptCo could still qualify for the aggregation rule if it satisfies the control test. Under the control test, ExemptCo may aggregate the trades or businesses in which it indirectly invests through a partnership if ExemptCo holds no more than 20 percent of the capital interest of the partnership, and does not control the partnership. For purposes of these rules, control is a facts and circumstances determination that looks to the ability of ExemptCo to direct the partnership’s action or operations, or to appoint partnership officers or a majority of the partnership’s directors.
The same result can be reached if ExemptCo invests in multiple partnerships. Let’s say that instead of the prior example, ExemptCo invests in LLC 1, which operates the office building at a loss, and also in LLC 2, which operates the food and beverage distribution business. Similar to the prior example, ExemptCo should still be able to aggregate the activities of LLC 1 and LLC 2 as a single investment activity for UBTI purposes, and recognize only the net UBTI of $20. The reason for this result is that the proposed regulations state that ExemptCo’s investment activities are aggregated as a single trade or business. The proposed regulations define investment activities to include “qualified partnership interests,” which are the direct interests in a partnership held by ExemptCo which meet certain ownership and control tests. The black-letter law of the proposed regulations aggregate all investment activities into a single activity, meaning all qualified partnership interests are aggregated for purposes of calculating UBTI. Accordingly, the taxable activities of LLC 1 and LLC 2 would be aggregated and treated as one trade or business for the UBTI calculation. Note that, similar to the prior example, ExemptCo would need to meet either the de minimis or control test discussed above with respect to both LLC 1 and LLC 2 to use this aggregation rule.
To further illustrate the impact of these rules, let’s assume that ExemptCo invests into LLC 1 and LLC 2, both investments meeting the ownership and control tests. LLC 1 invests in multiple lower-tier partnerships from which it derives various items of income and loss, which, once aggregated, lead to a $100 loss. LLC 2, on the other hand, owns stock in BlockCo, a corporation, which it sells for a $100 gain. Under normal rules, the capital gains from the sale of stock would not be UBTI. If, however, LLC 2 had initially acquired its interest in BlockCo utilizing acquisition indebtedness, and the debt remained outstanding within the 12-month period preceding the sale of BlockCo stock by LLC 2, ExemptCo has debt-financed income resulting from the sale of BlockCo, which would be UBTI. Similar to the examples above, however, there is hope for ExemptCo, because the definition of investment activities also includes debt-financed income. Accordingly, because the plain language of the Proposed Regulations aggregates all investment activities into a single activity for UBTI purposes, the gain from the sale of BlockCo would be aggregated with the loss from LLC 1’s various trades or businesses. While not as beneficial as the situation in which the sale of BlockCo stock is not UBTI, the aggregation rule prevents ExemptCo from paying U.S. federal income tax on $100 of UBTI, while carrying forward a loss $100 with respect to its investment in LLC 1.
Troutman Pepper Perspective
The recently released proposed regulations provide much needed guidance and assistance to exempt organizations which invest in private equity funds. By allowing for aggregation of investment income through tiered-partnership structures, in many cases exempt organizations will be able to offset losses from UBTI activities with losses from other such income, and therefore be subject to tax only on net UBTI.