June 30, 2020 / North America
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…
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