In April, the Treasury released proposed regulations under section 512(a)(6) (the UBIT Silo Rules), enacted as part of the TCJA, which requires tax-exempt organizations to calculate their unrelated business taxable income (UBTI) separately for each unrelated trade or business. The proposed regulations ease the rules provided in Notice 2018-67 for aggregating unrelated trade or business activity allowing additional activities to be treated as one for this purpose. These rules will have a significant impact on funds that include tax-exempt investors and on tax-exempt organizations that generate UBTI from multiple sources, including investments in partnerships. For example, certain tax-exempt organizations may incur incremental tax compliance burdens and incremental tax liability as a result of the UBIT Silo Rules. 

In this article, we discuss the material provisions of the proposed regulations, highlight certain significant changes with respect to prior guidance provided by the IRS in Notice 2018-67, and flag certain important issues that remain open.

Overview of UBTI

The UBTI rules are relevant because a tax-exempt organization generally pays income tax (also referred to as unrelated business income tax or UBIT) with respect to UBTI. So what is UBTI? UBTI generally refers to the income of a tax-exempt organization from business activities that are unrelated to its tax-exempt purpose. Dividends, interest, royalties,  and gains from the sale of property are generally not taxable.   However, if property is acquired with debt, this investment income may be taxable as unrelated debt financed income.  With respect to investments in partnerships, the UBTI rules treat the activities of a partnership as the activities of its partners. 

What has changed?

Prior to the TCJA, tax-exempt organizations with multiple sources of UBTI calculated their total UBTI as the aggregate gross income from all unrelated trades or businesses less the aggregate deductions attributable to such income. 

After the TCJA, effective for taxable years beginning after December 31, 2017, the UBIT Silo Rules require that UBTI be calculated separately for each unrelated trade or business and then aggregated. For purposes of aggregating the separate UBTIs of all unrelated trades or businesses, no individual trade or business is treated as having UBTI less than zero. As a result, the total UBTI of the organization will be the sum of each positive UBTI from each separate unrelated trade or business. 

A&M Taxand Observation: The UBIT Silo Rules prevent the offset of the loss of one unrelated trade or business against income of another. The IRS has often argued that activities that consistently produced losses were not engaged in for profit and so did not constitute trades or businesses, so that losses from such activities could not be taken into account in determining UBTI. The UBIT Silo Rules are intended to eliminate the argument over taxpayer intent. However, these examination disputes will likely continue since pre-TCJA net operating losses are still aggregated.

When enacted, the UBIT Silo Rules did not provide guidance on the determination of whether two or more unrelated trades or businesses constitute separate unrelated trade or business activities. For example, do we aggregate all manufacturing activities as one trade or business or, alternative, do we go deeper and aggregate, e.g., food manufacturing as one activity and clothes manufacturing as another? 

Guidance provided to date

In 2018, the IRS issued Notice 2018-67 to provide interim guidance on the implementation of the UBIT Silo Rules. Although the Notice included certain initial implementing rules, it also included many requests for guidance from tax-exempt organizations and the tax community. In April 2019, the proposed regulations were released, which generally expand on guidance provided by the Notice and clarify certain issues identified therein. Until the proposed regulations are effective, tax-exempt organizations are allowed to rely on (i) a reasonable, good-faith interpretation of sections 511 through 514 (the rules that define and compute UBTI and UBIT); (ii) Notice 2018-67; or (iii) the proposed regulations, if applied in their entirety. In light of these options, below is a summary of certain key provisions of the proposed regulations and certain key differences from Notice 2018-67.

How can separate unrelated trade or business activities be identified?

The proposed regulations allow an organization to aggregate unrelated trades or business activities based on NAICS 2-digit codes, which results in up to 20 possible categories. This represents a significant reduction in the number of possible categories from Notice 2018-67, which provided that the use of 6-digit codes was a reasonable good-faith interpretation, which results in over 1,000 possible categories. 

In addition to allowing aggregation based on 2-digit NAICS codes, the proposed regulations would allow four additional categories of activities to be aggregated:

1. Separate activities conducted through a partnership interest acquired prior to August 21, 2018 under the transition rule (until the regulations are effective);
2. Certain investment activities;
3. Certain income from controlled entities (e.g., subpart F inclusions attributable to insurance activities); and
4. Separate activities conducted through an S corporation (other than qualifying S corporation interests (QSCIs), which are treated as investment activities, as discussed below). 

The proposed regulations expand on the Notice, which excludes rules for interest in S corporations and certain income from controlled entities.

What activities can be treated as “investment activities”? 

The proposed regulations provide that investment activities are limited to (i) qualifying partnership interests (QPIs), (ii) unrelated debt financed income, and (iii) QSCIs, each briefly discussed below.

a) QPIs – in general, to be a QPI, the partnership interest must represent either:

1. no more than 2% of the profits interests and no more than 2% of the capital interests in the partnership (the de minimis test); or 

2. no more than 20% of the capital interests, if the tax-exempt organization does not have control over the partnership, considering all facts and circumstances (the control test).

By contrast, the Notice requires that the organization does not have control or influence over the partnership, a vague definition that could exclude many partnership interests. 

Thus, do we just count QPIs held directly by the tax-exempt organization? The short answer is no. There are two rules that should be considered: a related party rule and a look-through rule. 

The related party rule: Interests in the same partnership held by (1) certain persons who can exercise substantial influence over the affairs of the organization (i.e., a disqualified person), (2) certain organizations that are operated, supervised, or controlled by the applicable organization (i.e., supporting organizations), or (3) certain entities controlled by the organization are aggregated only for purposes of the control test, but not for purposes of the de minimis test. Under the Notice, these interests are required to be aggregated for both tests.

The look-through rule: If partnership interests held directly fail to satisfy the de minimis test and the control test solely because the tax-exempt organization holds more than 20% of the capital interest (i.e., there is otherwise no control after taking into account all facts and circumstances), then the organization can look through the directly-held partnership and treat an interest in a lower-tier partnership as a QPI if the lower-tier partnership interest satisfies the de minimis test. For example, if an organization owns 25% (profits and capital) of Upper-Tier Partnership and Upper-Tier Partnership owns 4% of Lower-Tier Partnership, the organization can look through Upper-Tier Partnership and treat the interests in Lower-Tier Partnership as a QPI since the de minimis test is satisfied as the organization effectively owns 1% (25% of 4%) of Lower-Tier Partnership (assumes no control under all facts and circumstances). However, an organization may apply either the transition rule (as discussed above) or the look-through rule, but not both, to a partnership interest that meets the requirements for both rules. 

b) Unrelated debt financed income – Unlike the Notice, which allowed only unrelated debt financed income attributed to QPIs to be included in the investment activity category, the proposed regulations allow unrelated debt financed income to be treated as an investment activity, unless such income is also treated as UBTI and attributable to non-investment activities.

c) QSCIs – To qualify as a QSCI, the S corporation interest must satisfy the QPI requirements. 

A&M Taxand Observation: The guidance allowing the aggregation of investment activities is favorable to tax-exempt organizations and is expected to ameliorate the adverse tax consequences of the UBIT Silo Rules. Depending on the specific facts and circumstances of the particular organization (e.g., multiple partnership interests in investment funds), it may consider requesting or requiring side letters from funds to ensure compliance with these rules, or participating through C corporations going forward. In addition, the guidance is also favorable to funds because it would significantly reduce the disclosures that a fund may be required to provide to its tax-exempt investors. For example, it may not be necessary to disclose information related to lower-tier partnerships on an activity-by-activity basis.

A&M Taxand Observation: Since an S corporation cannot have more than one class of stock, the de minimis and control tests should be based on ownership of the single class of stock. However, when analyzing the control test, a tax-exempt organization is recommended to consider differences in voting right (if any) among shares of stock, even though such differences are disregarded for purposes of S corporation classification.

What methodology can be used to allocate expenses to a trade or business activity?

The proposed regulations and the Notice provide that expenses which are directly connected with an unrelated trade or business activity are allocated to that activity. On the other hand, shared expenses are allocated between tax-exempt and non-tax-exempt activities and among unrelated trade or business activities under a reasonable allocation method. 

A&M Taxand Observation: The IRS recognizes that the allocation of shared expenses between tax-exempt and non-tax-exempt use assets has been an issue for years. A&M can help tax-exempt clients make this determination. The Treasury Department and the IRS are considering providing specific standards for allocation of shared expenses, rather than simply requiring the use of a reasonable allocation method.

There are specific rules for NOLs.

NOLs generated in taxable years beginning before January 1, 2018 (pre-2018 NOLs) that are carried forward to 2018 and later years can be used to offset gross income from any unrelated trade or business regardless of which unrelated trade or business generated the NOL. However, NOLs generated in a taxable year that begins after December 31, 2017 (post-2017 NOLs) and are carried forward can reduce taxable income only from the unrelated trade or business activity which gave rise to the loss. The proposed regulations clarify that when a tax-exempt organization has an NOL carryforward that includes both a pre-2018 NOL and a post-2017 NOL, the pre-2018 NOL is used first to reduce total UBTI before applying a post-2017 NOL. For this purpose, the proposed regulations note that pre-2018 NOLs are deducted from total UBTI in a manner that results in maximum utilization of the pre-2018 NOLs in a taxable year.

While the proposed regulations and the Notice do not address changes made to the NOL provisions under the CARES Act, the IRS recently provided responses to certain frequently asked questions (FAQs) on the interaction between the UBIT Silo Rules and the NOL carryback rules under the CARES Act. The IRS stated that when a tax-exempt organization carries back an NOL generated in 2018, 2019 or 2020 to a year before the UBIT Silo Rules became effective, the tax-exempt organization can deduct the NOL against total UBTI. While IRS FAQs are not binding authority, the FAQs address many of the areas of uncertainty about this issue.

A&M Taxand Observation: Many practitioners were concerned that an NOL generated in 2018, 2019, or 2020 (each a year in which the UBIT Silo Rules apply) could have been carried back to a year in which the UBIT Silo Rules do not apply but only to reduce UBTI attributable to the activity that generated the NOL. Therefore, these IRS FAQs are welcomed by tax-exempt organizations. Certain tax-exempt organizations have asked Treasury to incorporate this guidance in the final regulations.

Similar to ordinary corporations, for pre-TCJA taxable years, a tax-exempt organization subject to tax on its UBTI may be subject to the alternative minimum tax (AMT). Thus, if an NOL carryback results in AMT liability for the carryback year, that AMT generates a minimum tax credit that can be carried forward and may result in an overpayment in a later year for which a refund claim can be made. Tax-exempt organizations are recommended to consider the collateral consequences of an NOL carryback claim under the CARES Act. We have issued Tax Alerts on these issues which can be accessed here.

GILTI and Subpart F income

The proposed regulations and the Notice provide that a subpart F inclusion attributable to controlled foreign corporation is not UBTI, unless it is related to insurance income. But GILTI is not UBTI even if related to insurance activities.

No guidance for COD income

Despite the wave of debt restructurings triggered by the COVID-19 pandemic, no guidance has yet been provided as to whether the cancellation of indebtedness (COD) income can be UBTI and, if so, how COD income (and related expenses) should be treated for purposes of the UBIT Silo Rules. One possible view is that COD income can be UBTI if it is attributable to debt associated with an unrelated trade or business, or debt that would have generated unrelated debt financed income. This approach appears to be reasonable and consistent with the tracing principles that generally apply to determine UBTI and unrelated debt financed income. Under the same tracing principles, if COD income is attributable to unrelated trade or business activities for UBTI purposes, then a reasonable interpretation could be that COD income is also attributed to that activity for purposes of the UBIT Silo Rules. 

A&M Taxand Says

The UBIT Silo Rules are expected to have a material effect on many tax-exempt organizations that generate UBTI from various sources. We expect that many organizations that invest in investment funds will be affected by these rules. This may result in incremental administrative burdens for both the tax-exempt organizations and the funds, which may be required to provide more detailed information to tax-exempt investors than in the past. In addition, since many investments generate losses in the early years, certain organizations are expected to incur additional income tax, or may incur income tax earlier than under prior law. As a result, the availability of options for implementing the UBIT Silo Rules provides an opportunity to choose among methods available prior to the finalization of the proposed regulations. In addition, as a result of the new rules, tax-exempt entities may revisit their choice of investment vehicles. For example, they invest through a C corporation or participate in an unrelated business directly. Finally, there are still many unanswered questions (such as the manner of allocating shared expenses and the treatment of COD income). 

A&M is well-positioned to assist funds to appreciate the ramifications of the UBIT Silo Rules for their tax-exempt investors, as well as assist tax-exempt organizations to determine the effect of the UBIT Silo Rules on their tax obligations, analyze the overall tax implications among the available options (such as whether to apply the proposed regulations or the Notice) based on the organization’s unique facts and circumstances, or analyze any potential restructuring (e.g., insert a C corporation to hold unrelated trades or businesses) to mitigate the impact of the UBIT Silo Rules.