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Jan 13, 2021

IRS Issues Final Regulations for Applying UBTI ‘Silo’ Rules to Tax-Exempt Organizations

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IRS ISSUES FINAL REGULATIONS FOR APPLYING UBTI ‘SILO’ RULES TO TAX-EXEMPT ORGANIZATIONS

On November 30, 2020, the U.S. Department of Treasury (“Treasury”) and the IRS issued final regulations (T.D. 9933) on how an exempt organization determines if it has more than one unrelated trade or business, and, if so, how the exempt organization calculates its unrelated business taxable income (the “Final Regulations”).[1] The Final Regulations address guidance under Section 512(a)(6) of the Internal Revenue Code of 1986, as amended (the “Code”)[2] and largely adopt proposed regulations (REG-106864-18) issued in April 2020 (the “Proposed Regulations”), as summarized in our previous publication titled “Proposed Regulations Clarify UBTI ‘Silo’ Rules, Preserve Relief for Tax-Exempt Investments in Private Equity Funds.

Background

Under Section 511(a)(1), an exempt organization is subject to tax on unrelated business taxable income (UBTI) derived from any unrelated trade or business it regularly carries on, less certain deductions. Section 513(a) defines “unrelated trade or business” as consisting generally of any trade or business the conduct of which is not substantially related to the organization’s charitable, educational or other purpose or function constituting the basis for its tax exemption.

An exempt organization may engage in more than one unrelated trade or business. Prior to the enactment of Section 512(a)(6) under the Tax Cuts and Jobs Act (P.L. 115-97) (the TCJA), an exempt organization deriving gross income from two or more unrelated trades or businesses would calculate UBTI by determining its aggregate gross income from all such unrelated trades or businesses[3] and reducing that amount by the aggregate deductions allowed with respect to such unrelated trades or businesses. Section 512(a)(6) now requires an exempt organization to utilize a “silo” approach and calculate UBTI separately with respect to each unrelated trade or business. Thus, under section 512(a)(6), an exempt organization will be prohibited from using deductions and net losses from one or more trades or businesses to offset income from other unrelated trades or businesses when calculating UBTI. Congress did not provide explicit criteria under the TCJA 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 the new statute, leaving it to Treasury and the IRS to formulate guidance in this regard as discussed below.

Notice 2018-67

The IRS issued Notice 2018 - 67 on August 21, 2018 outlining interim guidance for implementing Section 512(a)(6) (the “2018 Notice”).[4] The 2018 Notice provided that an exempt organization could rely on a “reasonable, good - faith interpretation of Sections 511 through 514, considering all the facts and circumstances” until the Proposed Regulations were issued. A “reasonable, good-faith interpretation” included identifying a particular trade or business by the 6-digit code assigned under the North American Industry Classification System (NAICS). Furthermore, the 2018 Notice acknowledged the high administrative burden associated with requiring an exempt organization to calculate UBTI separately with respect to each unrelated trade or business regularly carried on by a lower-tier partnership (e.g., a private equity fund investment). The 2018 Notice responded to this concern by allowing an exempt organization to aggregate items of UBTI from lower-tier partnership investments meeting a “de minimis test” or a “control test” as set forth in the 2018 Notice. Treasury and the IRS incorporated these concepts into the Proposed Regulations and the Final Regulations, subject to a few modifications as discussed in more detail below.

Identifying Each Separate Unrelated Trade or Business

After considering comments to the 2018 Notice regarding the reporting burden associated with NAICS 6-digit codes, Treasury and the IRS provided under the Proposed Regulations that an exempt organization generally will identify each separate unrelated trade or business using only the first two digits of the NAICS codes.[5] The first two digits of the NAICS code designate the sector, each of which represents a general category of economic activity, such as retail trade (44–45); real estate, rental and leasing (53); or accommodation and food services (72), to name a few. There are only 20 2-digit NAICS codes in all, which should limit the number of unrelated trades or businesses that may apply to any particular exempt organization.

Consistent with the Proposed Regulations, the Final Regulations continue to provide that an exempt organization generally will identify each separate unrelated trade or business using only the first two digits of the NAICS codes, and that each NAICS 2-digit code must identify the separate unrelated trade or business in which the exempt organization engages (directly or indirectly).[6] The Final Regulations provide additional guidance for identifying the appropriate NAICS 2-digit code, and clarify that if trade or business activities would be best described by different NAICS 2-digit codes, those activities should be identified using different NAICS 2-digit codes and treated as separate unrelated trades or businesses.[7]

The Final Regulations relax the requirements for changing the NAICS code applicable to a particular activity. The Proposed Regulations provide that, once an exempt organization identifies a separate unrelated trade or business using a particular NAICS 2-digit code, the exempt organization is prohibited from changing that NAICS 2-digit code unless the exempt organization demonstrates that another NAICS 2-digit code more accurately describes the unrelated trade or business and that the original designation was due to unintentional error.[8] In response to comments, the Final Regulations remove the restriction on changing NAICS 2-digit codes and instead require an exempt organization to report the change in accordance with forms and instructions.[9]

Aggregation of Investment Activities

The Final Regulations adopt the approach set forth in the Proposed Regulations for aggregating all of an exempt organization’s investment activities as a separate “unrelated trade or business” for purposes of Section 512(a)(6).[10] For this purpose, the Final Regulations adopt the exclusive list of qualifying investment activities set forth in the Proposed Regulations consisting of: (i) “qualifying partnership interests,” (ii) “debt-financed properties,” and (iii) “qualifying S corporation interests.”[11] Each is discussed in turn below. 

Qualifying Partnership Interests. Under the Final Regulations, a partnership interest is a qualifying partnership interest (QPI) if it meets the requirements of a “de minimis test” or a “participation test” as discussed below.[12] The “participation test” is functionally similar to the “control test” described in the Proposed Regulations and the 2018 Notice, with a few modifications.

With respect to the “de minimis test,” the Proposed Regulations provide that a partnership interest will qualify as a QPI for a particular year if the exempt organization holds directly or indirectly no more than two percent of the profits interests and no more than two percent of the capital interests of the partnership during the exempt organization’s taxable year with which or in which the partnership’s taxable year ends.[13] The Final Regulations adopt the tiered partnership provisions set forth in the Proposed Regulations which permit exempt organizations to ignore certain directly-held interests in upper-tier partnerships.[14] In this regard, the Final Regulations provide an example where an exempt organization directly holds 50 percent of the capital interests of an upper-tier partnership “XYZ.” Partnership “XYZ” holds four percent of the capital and profits interests of lower-tier partnership “A.” Under this example in the Final Regulations, the exempt organization is permitted to aggregate its interests in applying the de minimis test to characterize the interest in lower-tier partnership “A” as a QPI.[15]

With respect to the “participation test,” the Final Regulations modify the approach taken in the Proposed Regulations by focusing on whether the exempt organization “significantly participates” in the partnership, rather than whether it “controls” the partnership based on a facts and circumstances analysis. In this regard, under the Final Regulations, a partnership interest will qualify as a QPI for a particular year if the exempt organization directly or indirectly holds no more than 20 percent of the capital interest of the partnership during the exempt organization’s taxable year with which or in which the partnership’s taxable year ends and the exempt organization does not “significantly participate” in the partnership based on specific factors.[16] The Final Regulations list four specific factors where the exempt organization will be deemed to “significantly participate” for this purpose: (i) the exempt organization, by itself, may require the partnership to perform, or prevent the partnership from performing, (other than through a unanimous voting requirement or through minority consent rights), any act that significantly affects the operations of the partnership, (ii) any of the exempt organization’s officers, directors, trustees or employees have a right to participate in the management of the partnership, (iii) any of the exempt organization’s officers, directors, trustees or employees have a right to conduct the partnership’s business at any time, or (iv) the exempt organization has the right to remove any of the partnership’s officers or employees or a majority of its directors.[17]

Debt-Financed Properties. Under the Final Regulations, all items of UBTI under Section 512(b)(4) from an exempt organization’s debt-financed property or properties (and not just its unrelated debt-financed income arising in connection with a QPI as provided in the 2018 Notice) in the list of “investment activities” treated as a separate unrelated trade or business for purposes of Section 512(a)(6).[18]

Qualifying S-Corporation Interests. The Final Regulations will permit exempt organizations to aggregate items of UBTI received with respect to an interest in an S corporation with UBTI from other investment activities if the exempt organization’s stock ownership (by percentage) in the S corporation meets the requirements provided in the “de minimis test” or the “participation test” for QPIs, discussed above.[19] Any interest in an S corporation not meeting such requirements will be treated as a separate unrelated trade or business, regardless of groupings based on NAICS codes.[20]

QPI Transition Rule

The Final Regulations provide for a transition period during which any directly-held partnership interest acquired before August 21, 2018 that is not a QPI will nevertheless qualify as a single separate unrelated trade or business for purposes of Section 512(a)(6) even if the partnership engages in multiple unrelated trades or businesses directly or through one or more lower-tier partnerships.[21] An exempt organization will remain eligible for relief under the transition rule even if the exempt organization’s percentage interest in a partnership changes during the transition period. The transition period would end on the first day of an exempt organization’s first taxable year beginning after December 2, 2020.[22]

Footnotes

[1]  T.D. 9933, 85 FR 77979, Dec. 2, 2020.
[2]  Unless otherwise indicated, all “section” references herein are to sections of the Code.
[3]  See Reg. § 1.512(a)–1(a).
[4]  Notice 2018-67; 2018-36 IRB 409.
[5]  Prop. Reg. § 1.512(a)-6(b)(1).
[6]  Reg. § 1.512(a)-6(b)(1).
[7]  Reg. § 1.512(a)-6(b).
[8]  Prop. Reg. § 1.512(a)-6(b)(3).
[9]  Reg. § 1.512(a)-6(a)(3).
[10]  Reg. § 1.512(a)-6(c)(1).
[11]  Id.
[12]  Reg. § 1.512(a)-6(c)(2)(i).
[13]  Reg. § 1.512(a)-6(c)(3).
[14]  Reg. § 1.512(a)-6(c)(2)(ii)(A).
[15]  Reg. § 1.512(a)-6(c)(2)(ii)(B).
[16]  Reg. § 1.512(a)-6(c)(4)(i).
[17]  Reg. § 1.512(a)-6(c)(4)(iii).
[18]  Reg. § 1.512(a)-6(c)(1)(iii).
[19]  Reg. § 1.512(a)-6(e)(2).
[20]  Reg. § 1.512(a)-6(e)(1).
[21]  Reg. § 1.512(a)-6(c)(9)(i).
[22]  Reg. § 1.512(a)-6(c)(9)(iii).

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