# Unrelated Business Taxable Income Separately Computed for Each Trade or Business

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-06604

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** April 24, 2020
- **Citation:** 85 FR 23172

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[REG-106864-18]
RIN 1545-BO79
Unrelated Business Taxable Income Separately Computed for Each Trade or Business

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations that provide guidance on how an exempt organization subject to the unrelated business income tax described in section 511 of the Internal Revenue Code (Code) determines if it has more than one unrelated trade or business, and, if so, how the exempt organization calculates unrelated business taxable income. The proposed regulations also clarify that the definition of “unrelated trade or business” applies to individual retirement accounts. Additionally, the proposed regulations provide that inclusions of subpart F income and global intangible low-taxed income are treated in the same manner as dividends for purposes of section 512. The proposed regulations affect exempt organizations.

DATES:

Written or electronic comments and requests for a public hearing must be submitted by June 23, 2020.

ADDRESSES:

Submit electronic submissions via the Federal eRulemaking Portal at
www.regulations.gov
(indicate IRS and REG-106864-18) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG-106864-18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed rules, Jonathan A. Carter at (202) 317-5800; concerning submissions of comments and requests for a public hearing, Regina Johnson at (202) 317-5177 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Under section 501(a) of the Code, organizations described in sections 401(a) and 501(c) generally are exempt from federal income taxation. However, section 511(a)(1) imposes a tax (computed as provided in section 11) on the unrelated business taxable income (UBTI) of organizations described in section 511(a)(2), which includes organizations described in sections 401(a) and 501(c) (other than a trust described in section 511(b) or an instrumentality of the United States described in section 501(c)(1)), as well as state colleges and universities. Additionally, section 511(b)(1) imposes a tax (computed as provided in section 1(e)) on the UBTI of trusts described in section 511(b)(2), which describes trusts that are exempt from federal income taxation under section 501(a) and which, if it were not for such exemption, would be subject to subchapter J of chapter 1 of the Code (relating to estates, trusts, beneficiaries, and decedents). Organizations described in section 511(a)(2) and trusts described in section 511(b)(2) are collectively called “exempt organizations” or “organizations” throughout this preamble, unless otherwise stated.
1

1
Section 408(e) states that an individual retirement account (IRA) is subject to the taxes imposed by section 511. Accordingly, any reference to an exempt organization in this preamble includes an IRA, without regard to whether it is a traditional IRA, Roth IRA, simplified employee pension (SEP-IRA), or savings incentive match plan for employees (SIMPLE IRA). See section 9 of this preamble for more information.

Definitions of UBTI

Section 512 provides two different definitions of UBTI—one in section 512(a)(1), which applies to most exempt organizations, and one in section 512(a)(3), which applies only to social clubs described in section 501(c)(7), voluntary employees' beneficiary associations (VEBAs) described in section 501(c)(9), and supplemental unemployment compensation benefits trusts (SUBs) described in section 501(c)(17).

Section 512(a)(1) defines UBTI as the gross income derived by any exempt organization from an unrelated trade or business regularly carried on by it, less the deductions allowed by chapter 1 of the Code (chapter 1) that are directly connected with the carrying on of such trade or business, both computed with the modifications described in section 512(b). Section 513(a) generally defines “unrelated trade or business” as any trade or business the conduct of which is not substantially related (aside from the need of such exempt organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such exempt organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 (or, in the case of a state college or university, to the exercise or performance of any purpose or function described in section 501(c)(3)). However, in the case of a trust that is exempt from tax under section 501(a) and described in section 401(a) (qualified retirement plans) or section 501(c)(17) (SUBs), section 513(b) defines “unrelated trade or business,” as any trade or business regularly carried on by such trust or by a partnership of which it is a member. Section 1.513-1(b) generally provides that, for purposes of section 513, the term “trade or business” has the same meaning as in section 162.

By contrast, section 512(a)(3)(A) defines UBTI as the gross income (excluding exempt function income), less the deductions allowed by chapter 1 that are directly connected with the production of the gross income (excluding exempt function income), both computed with the modifications described in section 512(b)(6) (net operating loss (NOL) deduction), (b)(10) (charitable contribution deduction by exempt organizations), (b)(11) (charitable contribution deduction by certain trusts), and (b)(12) (specific deduction). Accordingly, UBTI under section 512(a)(3) is not limited to the gross income derived by an exempt organization from any unrelated trade or business regularly conducted by it. Thus, any gross income that is not exempt function income (nonexempt function income) is UBTI under section 512(a)(3).

Unrelated Trades or Businesses Conducted Indirectly Through Another Entity

An exempt organization may conduct an unrelated trade or business directly or indirectly through another entity, such as a partnership (including any entity treated as a partnership for federal tax purposes). Section 512(c) provides that, if a trade or business regularly carried on by a partnership of which an exempt organization is a partner is an unrelated trade or business with respect to such exempt organization, the exempt organization includes in UBTI—subject to the exceptions, additions, and limitations of section 512(b)—its distributive share of partnership gross income (whether or not distributed) and partnership deductions directly connected with

such gross income.
See
§ 1.512(c)-1 (describing how UBTI is calculated in a situation in which an exempt organization's distributive share of partnership income consists of both UBTI and income that is excluded from the calculation of UBTI). In determining whether a partnership conducts a trade or business that is an unrelated trade or business with respect to an exempt organization partner, the exempt organization would use the applicable definition of “unrelated trade or business” in section 513(a) or (b). Section 512(c) applies regardless of whether an exempt organization is a general or limited partner.
See
Rev. Rul. 79-222, 1979-2 C.B. 236.

Calculation of UBTI

An exempt organization may engage in more than one unrelated trade or business. Prior to the enactment of section 512(a)(6), an exempt organization deriving gross income from the regular conduct of two or more unrelated trades or businesses calculated UBTI by determining its aggregate gross income from all such unrelated trades or businesses and reducing that amount by the aggregate deductions allowed with respect to all such unrelated trades or businesses.
See
§ 1.512(a)-1(a). However, section 512(a)(6), which was added to the Code by section 13702 of Public Law 115-97, 131 Stat. 2054 (2017), commonly referred to as the Tax Cuts and Jobs Act (TCJA), enacted December 22, 2017, changed this calculation for exempt organizations with more than one unrelated trade or business so that, in the case of any exempt organization with more than one unrelated trade or business:

(A) UBTI, including for purposes of determining any NOL deduction, shall be computed separately with respect to each trade or business and without regard to section 512(b)(12) (allowing a specific deduction of $1,000),

(B) The UBTI of such exempt organization shall be the sum of the UBTI so computed with respect to each trade or business, less a specific deduction under section 512(b)(12), and

(C) For purposes of section 512(a)(6)(B), UBTI with respect to any such trade or business shall not be less than zero.

Thus, under section 512(a)(6), an exempt organization is no longer permitted to aggregate income and deductions from all unrelated trades or businesses when calculating UBTI. Section 512(a)(6) applies to taxable years beginning after December 31, 2017, but not to NOLs arising before January 1, 2018, that are carried over to taxable years beginning on or after such date.
See
section 13702(b) of the TCJA.

In August 2018, the Treasury Department and the IRS issued Notice 2018-67 (2018-36 IRB 409 (Sept. 4, 2018)), which discussed and solicited comments regarding various issues arising under section 512(a)(6) and set forth interim guidance and transition rules relating to that section. The Treasury Department and the IRS received 24 comments in response to Notice 2018-67 and considered these comments in drafting these proposed regulations. Some of these comments discussed the interaction between section 512(a)(6) and (7), which was also enacted by the TCJA and provided that an exempt organization's UBTI is increased by any amount for which a deduction is not allowable under chapter 1 by reason of section 274 and which is paid or incurred by such exempt organization for certain disallowed fringes. These comments are not discussed because section 512(a)(7) was repealed on December 20, 2019.
See
Further Consolidated Appropriations Act, 2020, Division Q, Public Law 116-94, 133 Stat. 2534 (2019) (retroactively effective to date of enactment of the TCJA). The remaining comments are discussed in the Explanation of Provisions and Comment Summary. The comments are available for public inspection upon request.

Explanation of Provisions and Summary of Comments

Section 512(a)(6) requires an exempt organization with more than one unrelated trade or business to first calculate UBTI separately with respect to each such trade or business, without regard to the specific deduction generally allowed under section 512(b)(12). The Conference Report explains that “[t]he organization's [UBTI] for the taxable year is the sum of the amounts (not less than zero) computed for each separate trade or business, less the specific deduction allowed under section 512(b)(12).” H.R. Rep. No. 115-466 (2017), at 548. Section 512(a)(6) continues to allow an NOL deduction, but “only with respect to a trade or business from which the loss arose.”
Id.
Thus, the legislative history states that “a deduction from one trade or business for a taxable year may not be used to offset income from a different unrelated trade or business for the same taxable year.”
Id.
at 548. Because section 512(a)(6) disallows the aggregation of income and deductions from all unrelated trades or businesses, these proposed regulations revise § 1.512(a)-1(a) to state that, in the case of an organization with more than one unrelated trade or business, UBTI is calculated separately with respect to each such trade or business as provided in new proposed § 1.512(a)-6.

Congress did not provide explicit 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 in accordance with section 512(a)(6).
2

Accordingly, these proposed regulations establish the method for determining whether an exempt organization has more than one unrelated trade or business for purposes of section 512(a)(6) and identifying separate unrelated trades or businesses for purposes of calculating UBTI under this section. These proposed regulations also clarify that, for purposes of the unrelated business income tax generally and the application of section 512(a)(6) specifically, an individual retirement plan (IRA) described in section 408(e) uses the definition of “unrelated trade or business” in section 513(b) applicable to trusts. Additionally, these proposed regulations clarify that inclusions of subpart F income under section 951(a)(1)(A) and global intangible low-taxed income (GILTI) under section 951A(a) are treated in the same manner as dividends for purposes of section 512(b)(1).

2
The Joint Committee on Taxation's General Explanation of Public Law 115-97 states that “it is intended that the Secretary issue guidance concerning when an activity will be treated as a separate unrelated trade or business for purposes of [section 512(a)(6)].” Staff of the Joint Committee on Taxation, General Explanation of Public Law 115-97 (December 2018), at 293.

1. Separate Unrelated Trade or Business

There is no general statutory or regulatory definition of what activities constitute a “trade or business” for purposes of the Code. Whether an activity constitutes a trade or business may vary depending on which Code section is involved.
See generally

Commissioner
v.
Groetzinger,
480 U.S. 23, 27 (1987). Section 1.513-1(b) of the current Treasury regulations (promulgated in 1967) states that, “for purposes of section 513, the term `trade or business' has the same meaning it has in section 162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services.”

Notice 2018-67 permitted a reasonable, good-faith interpretation of sections 511 through 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes

of section 512(a)(6). At the same time, Notice 2018-67 stated that the Treasury Department and the IRS were considering the use of the North American Industry Classification System (NAICS) codes as a method for determining whether an exempt organization has more than one unrelated trade or business for purposes of section 512(a)(6) and for purposes of calculating UBTI under section 512(a)(6)(A). NAICS is an industry classification system for purposes of collecting, analyzing, and publishing statistical data related to the United States business economy that results from a cooperative effort between Canada, Mexico, and the United States.
See
Executive Office of the President, Office of Management and Budget, North American Industry Classification System (2017) (2017 NAICS Manual),
available at

https://www.census.gov/eos/www/naics/2017NAICS/2017_NAICS_Manual.pdf.
The structure of NAICS is hierarchical, using a six-digit coding system.
Id.
at 16, 18, & 20. NAICS divides the economy into 20 sectors.
Id.
at 3. The first two digits of the code designate the sector, each of which represents a general category of economic activity, including retail trade (44-45); real estate and rental and leasing (53); health care and social assistance (62); and accommodation and food services (72).
Id.
at 16 & 20. The third digit designates the subsector; the fourth digit designates the industry group; and the fifth digit designates the NAICS industry. Any establishment is usually classified down to the NAICS five-digit industry level classification, using the classification of the industry that best matches its primary activity. When applicable, the sixth digit is used to designate the national industry, to reflect differences between the countries. A zero as the sixth digit generally indicates that the NAICS industry and the U.S. industry are the same.
Id.
at 18. Accordingly, each digit of the NAICS 6-digit codes describes an industry with increasing specificity.

In Notice 2018-67, the Treasury Department and the IRS provided that a reasonable, good-faith interpretation included using the most specific level—six-digit codes (NAICS 6-digit codes). The Treasury Department and the IRS also requested comments regarding rules to identify separate trades or businesses that achieve the intent of Congress in enacting section 512(a)(6) and that are administrable for exempt organizations and the IRS. As discussed further in section 1.a of this preamble, methods commenters suggested included devising a facts and circumstances test along with a clearly defined safe harbor, adopting principles described in various Code sections (including sections 183 and 469), using the groupings described in Form 14018, “Compliance Questionnaire Colleges and Universities,” and using less than six digits of the NAICS codes.

After considering the comments, the Treasury Department and the IRS continue to view an identification method based on NAICS codes as administrable for exempt organizations and the IRS. Moreover, in response to comments regarding the burden related to the specificity of NAICS 6-digit codes, the proposed regulations provide that an exempt organization generally will identify its separate unrelated trades or businesses using the first two digits of the NAICS codes (NAICS 2-digit codes).

a. The North American Industry Classification System (NAICS)

Most commenters that discussed NAICS supported using the NAICS codes to identify separate unrelated trades or businesses for purposes of section 512(a)(6). Nonetheless, several commenters generally opposed this proposed method. These commenters argued that the NAICS codes were not created to define “trade or business” for UBTI purposes and therefore fail to sufficiently describe the full range of possible unrelated trades or businesses engaged in by exempt organizations. While the Treasury Department and the IRS recognize that the NAICS codes were not specifically designed for use under section 512(a)(6), the Treasury Department and the IRS continue to believe that using the NAICS codes is appropriate because NAICS “is a comprehensive [classification] system covering all economic activities.” 2017 NAICS Manual, at 14. Additionally, the broad scope of activities covered by the NAICS 2-digit codes should cover all the unrelated trade or business activities conducted by exempt organizations.

The NAICS codes were developed, in coordination with Canada and Mexico, by the Office of Management and Budget (OMB) and are managed by the United States Census Bureau. The OMB reviews and updates the NAICS codes as appropriate every five years and, at times, may remove codes.
Id.
at 78. In responding to the NAICS 6-digit codes discussed in Notice 2018-67, some commenters expressed concern that the Treasury Department and the IRS do not control NAICS and that this could adversely impact organizations using the codes for tax purposes. The Treasury Department and the IRS view the proposal to use NAICS 2-digit codes as addressing this concern because the codes are revised through notice and comment rulemaking, and OMB has never revised the codes at the 2-digit level.

A few commenters noted that a recent report by the Treasury Inspector General for Tax Administration (TIGTA) determined that the NAICS codes are “unreliable for use to identify businesses that may be subject to excise tax reporting and payment.” Treasury Inspector General for Tax Administration, The Affordable Care Act: An Improved Strategy is Needed to Ensure Accurate Reporting and Payment of the Medical Device Excise Tax 5 (Jul. 17, 2014). The Treasury Department and the IRS consider the situation addressed by the TIGTA report to be distinguishable from the use of the NAICS 2-digit codes to identify separate unrelated trades or businesses for purposes of section 512(a)(6). The TIGTA report addressed the IRS's efforts to determine the population of taxpayers subject to the new medical device excise tax based on the NAICS 6-digit code a taxpayer had reported on Schedule K, “Other Information,” of Form 1120, “U.S. Corporation Income Tax Return” to identify the activity from which it derives the largest percentage of total receipts. TIGTA found that not every medical device manufacturer used the same NAICS 6-digit code to report the activity, such that reliance on one NAICS 6-digit code would not identify all businesses that may be subject to the tax. TIGTA also noted that the NAICS 6-digit code did not always signify a business that is engaged in taxable sales of medical devices. Here, an exempt organization will be reporting each of its separate unrelated trades or businesses using the more general NAICS 2-digit codes on Form 990-T, “Exempt Organization Business Income Tax Return,” for the purpose of ensuring compliance with section 512(a)(6). As previously discussed, the NAICS 2-digit code describes a broader sector of the economy, making it more likely that taxpayers engaged in similar activities that could be described in more than one NAICS 6-digit code will nonetheless report those activities as part of the same overall sector.

i. NAICS 2-Digit Codes

As discussed in section 1 of this preamble, Notice 2018-67 permitted reliance on NAICS 6-digit codes as a method of identifying separate trades or businesses and requested comments regarding whether use of less than six digits of the NAICS codes, either alone or in combination with one or more other methods, would appropriately

identify separate trades or businesses for purposes of achieving the objectives of section 512(a)(6). Nearly all the commenters making recommendations on the NAICS codes rejected the use of NAICS 6-digit codes. These commenters noted that using NAICS 6-digit codes would result in significant administrative burden because an exempt organization would have to determine which of over 1,000 NAICS 6-digit codes most accurately describes its trades or businesses. Commenters noted that many NAICS 6-digit codes may apply to more than one trade or business activity or that no NAICS 6-digit code may exist to accurately describe a trade or business activity. Additionally, these commenters argued that the use of NAICS 6-digit codes could potentially require an exempt organization to split what has traditionally been considered one unrelated trade or business activity into multiple trades or businesses.

Half of the commenters making recommendations on the NAICS codes suggested adoption of NAICS 2-digit codes, which would identify trades or businesses in 20 sectors. These commenters generally explained that use of NAICS 2-digit codes would result in broader, less subjective identification of trades or businesses that would naturally permit the aggregation of similar activities. Furthermore, one of these commenters stated that the use of fewer digits of the NAICS codes would minimize implementation costs and reduce the administrative burden on the IRS as well as exempt organizations. This commenter opined that the NAICS 2-digit codes are less likely to change over time than the NAICS codes with more digits because the specificity of the NAICS codes increases as digits are added. NAICS 3-digit codes, which one commenter recommended adopting, identify 99 subsectors. By contrast, NAICS 4-digit codes, which two commenters recommended adopting, identify 311 industry groups.

The Treasury Department and the IRS recognize that limitations exist in using NAICS as a method of identifying an exempt organization's separate unrelated trades or businesses. However, the Treasury Department and the IRS conclude that adopting the NAICS 2-digit codes will minimize those limitations and that NAICS 2-digit codes are less likely to change over time than NAICS codes with more digits. At the same time, adoption of NAICS 2-digit codes will not allow the offsetting of losses between the 20 sectors of unrelated trades or businesses. Additionally, under existing precedent, an organization must determine whether an activity is an “unrelated trade or business” within the meaning of section 513 before it determines what NAICS 2-digit code describes that “separate” unrelated trade or business. An organization cannot use losses from an activity that consistently generates losses to offset income from a profitable trade or business unless the organization can show that the loss-producing activity is conducted with the requisite profit motive.
See Portland Golf Club
v.
Commissioner,
497 U.S. 154, 164 (1990) (confirming that, “[a]lthough [section 162] does not expressly require that a `trade or business' must be carried on with an intent to profit, this Court has ruled that a taxpayer's activities fall within the scope of [section] 162 only if an intent to profit has been shown” and citing
Groetzinger,
480 U.S. at 35);
Losantiville Country Club
v.
Commissioner,
906 F.3d 468, 473-75 (6th Cir. 2018) (demonstrating profit motive without reference to profitability by applying section 183 factors).

Furthermore, the Treasury Department and the IRS conclude that use of NAICS 2-digit codes results in broader identification of trades or businesses that will minimize implementation costs and will mitigate the administrative burden on exempt organizations and the IRS that would be imposed by more detailed NAICS codes. The use of NAICS 2-digit codes should also reduce any inequity that might result from a code system that was not specifically designed to describe the business activities of exempt organizations.

For these reasons, the proposed regulations generally provide that an exempt organization will identify each of its separate unrelated trades or businesses using the first two digits of the NAICS code that most accurately describes a trade or business. The Treasury Department and the IRS request comments on whether another method, or additional methods, of identifying an exempt organization's separate unrelated trades or businesses better achieves the intent of Congress in enacting section 512(a)(6) while still being administrable for exempt organizations and the IRS.

A few commenters requested confirmation that the Treasury Department and the IRS will permit an exempt organization to rely on the NAICS code that describes all the activities of the organization. For example, NAICS describes educational services, which includes colleges, universities, and professional schools, under one NAICS 2-digit code (61).

An unrelated trade or business generally is any trade or business the conduct of which is not substantially related to the exercise or performance by such exempt organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501.
See
section 513(a). A NAICS code that describes all of an exempt organization's activities, even those activities that are substantially related to the exercise or performance of the exempt organization's exempt function, fails to identify the exempt organization's unrelated trades or businesses and undermines the Congressional intent in enacting section 512(a)(6). Accordingly, the proposed regulations clarify that the NAICS code chosen must identify the unrelated trade or business in which the exempt organization engages (directly or indirectly) and not the activities the conduct of which are substantially related to the exercise or performance by such exempt organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501 (or, in the case of an exempt organization described in section 511(a)(2)(B), to the exercise or performance of any purpose or function described in section 501(c)(3)). Thus, returning to the previous example, a college or university cannot choose NAICS code 61 for all its unrelated trade or business activities.

Similarly, one commenter requested that the Treasury Department and the IRS confirm that a qualified retirement plan can use the NAICS code describing employee benefit funds, which is included under the NAICS 2-digit code for finance and insurance (52), to describe all the plan's unrelated trades or businesses. As discussed in the Background section, qualified retirement funds are subject to the general definition of UBTI in section 512(a)(1) but the term “unrelated trade or business” is defined in a special rule for trusts under section 513(b) as “any trade or business regularly carried on by such [plan] or by a partnership of which it is a member.” Accordingly, it must use the NAICS 2-digit code that most accurately describes the underlying trade or business regularly carried on by the plan or by a partnership of which it is a member. However, it appears that qualified retirement plans generally derive most, if not all, of their UBTI from investment activities, the identification of which is discussed in section 2 of this preamble, and which includes UBTI from any qualifying partnership interests (see section 2.d of

this preamble) or qualifying S corporation interests (see section 4.a of this preamble). Accordingly, unless a qualified retirement plan engages directly in one or more unrelated trades or businesses or has non-qualifying partnership interests or non-qualifying S corporation interests, a qualified retirement plan will not be subject to section 512(a)(6) because it will only have one unrelated trade or business for purposes of section 512(a)(6)—its investment activities.

A social club described in section 501(c)(7) would not be able to use the NAICS 2-digit code for arts, entertainment, and recreation (71), which includes golf courses and country clubs, to identify all its unrelated trades or businesses. As explained in the Background section, social clubs are subject to the definition of UBTI in section 512(a)(3), which defines UBTI, in part, as “gross income (excluding exempt function income)” and does not refer directly to “any unrelated trade or business.” However, as further explained in section 5 of this preamble, these proposed regulations apply regardless of whether an organization is subject to the definition of UBTI in section 512(a)(1) or section 512(a)(3). Accordingly, a social club must use the NAICS code that most accurately describes its unrelated trade or business activities. The social club may use the NAICS 2-digit code for arts, entertainment, and recreation (71) only to the extent such code describes its unrelated trades or businesses, such as rounds of golf played by nonmembers, the greens fees for which would result in UBTI.

At least one commenter recommended that the proposed regulations permit an exempt organization to aggregate trades or businesses that may be described by multiple NAICS codes as a single trade or business when those activities are closely related, similar in nature, and essentially conducted as a single trade or business. Although the Treasury Department and the IRS recognize that the use of more digits of the NAICS codes could result in the division of business activities traditionally conducted as one unit into more than one trade or business, the use of NAICS codes at the 2-digit level, as noted by other commenters, results in the aggregation of trades or businesses in the same economic sector. Accordingly, the Treasury Department and the IRS address this comment by adopting the use of NAICS 2-digit codes.

ii. Codes Reported Only Once

The Treasury Department and the IRS recognize that an exempt organization can have a trade or business that it operates in different, geographic areas. For example, a hospital organization may operate several hospital facilities in a geographic area (or multiple geographic areas), all of which include pharmacies that sell goods to the general public.
See
Rev. Rul. 68-375, 1968-2 C.B. 245. Pharmacies are described under the NAICS 2-digit code for retail trade (44). Although each pharmacy potentially could be considered a “separate” trade or business under section 512(a)(6), particularly if separate books and records exist for each pharmacy, the Treasury Department and the IRS recognize that devising rules to distinguish between each pharmacy trade or business would introduce additional complexity and increase the administrative burden on the hospital organization. Accordingly, the proposed regulations provide that an exempt organization will report each NAICS 2-digit code only once. Thus, even though the hospital organization in the previous example operates more than one pharmacy, the hospital organization would report all the pharmacies using the NAICS 2-digit code for retail trade (44), along with any other retail trades or businesses described by this NAICS 2-digit code, on Form 990-T as one unrelated trade or business.

iii. Erroneous Codes

The proposed regulations provide that, once an exempt organization has identified a separate unrelated trade or business using a particular NAICS 2-digit code, the organization may not change the NAICS 2-digit code describing that trade or business unless the organization can show that the NAICS 2-digit code chosen was due to an unintentional error and that another NAICS 2-digit code more accurately describes the trade or business. This limitation will apply to codes reported on the first Form 990-T filed after final regulations under section 512(a)(6) are published in the
Federal Register
. The Treasury Department and the IRS anticipate that the instructions to the Form 990-T will be revised to describe how an exempt organization provides notification of such an error. Additionally, the Treasury Department and the IRS request comments regarding whether there are other circumstances in which an exempt organization should be permitted to change NAICS 2-digit codes.

b. New Identification Methods

At least two commenters suggested that the proposed regulations permit the Treasury Department and the IRS the flexibility to add new methods of identifying separate unrelated trades or businesses through guidance published in the Internal Revenue Bulletin. The Treasury Department and the IRS recognize that other code systems may exist (and have not yet been identified) or may be devised in the future that better reflect the unrelated trade or business activities engaged in by exempt organizations. However, the Treasury Department and the IRS also expect that the proposed regulations provide a method of identifying separate unrelated trades or businesses that is administrable for exempt organizations and the IRS and therefore do not anticipate the need to routinely modify that method. As more experience is gained over time with the administration of section 512(a)(6), the Treasury Department and the IRS may consider additional identification methods, including the use of code systems or indices other than NAICS, and will publish guidance as needed.

c. De Minimis Exceptions

One commenter recommended that the Treasury Department and the IRS adopt a de minimis exception for exempt organizations reporting less than $100,000 of gross UBTI. Relying on statistical data published by the IRS, the commenter states that such organizations were responsible for only five percent of the total unrelated business income tax paid in 2013. This commenter argued that small exempt organizations likely lack the internal staff and the resources to implement the changes required by the enactment of section 512(a)(6) and to engage outside professionals to assist with ongoing compliance with that section.

As a result of the commenter's proposed threshold, section 512(a)(6) would not apply to more than 80 percent of the exempt organizations filing Form 990-Ts (based on the statistical data cited by the commenter).
See
Table 4. Unrelated Business Income Tax Returns: Returns with Positive Unrelated Business Taxable Income: Number of Returns, Gross Unrelated Business Income (UBI), Total Deductions, Unrelated Business Taxable Income, and Total Tax, by Type of Entity and Size of Gross UBI Tax Year 2013,
available at

https://www.irs.gov/statistics/soi-tax-stats-exempt-organizations-unrelated-business-income-ubi-tax-statistics#2.
Accordingly, a supposed “de minimis”

rule with a $100,000 gross UBTI threshold would effectively render section 512(a)(6) a nullity for most exempt organizations.

More importantly, as noted by the commenter, section 512(a)(6) does not provide a de minimis rule and does not provide discretionary authority for the Treasury Department and the IRS to establish one. Accordingly, even at a lower threshold, a de minimis rule would be contrary to the stated Congressional intent of not permitting exempt organizations to use losses from one unrelated trade or business to offset the gains from another unrelated trade or business. However, the Treasury Department and the IRS note that the use of NAICS 2-digit codes, along with the treatment of an exempt organization's investment activities as one unrelated trade or business (as described in section 2.a of this preamble), is expected to address many of the concerns prompting the request for a de minimis rule because smaller entities are not as likely to have more than one unrelated trade or business. The Treasury Department and the IRS therefore do not adopt this comment.

d. Allocation of Directly Connected Deductions

i. In General

Section 512(a)(1) permits an exempt organization with an unrelated trade or business to reduce the income from that trade or business by the deductions allowed by chapter 1 that are directly connected with the carrying on of such trade or business. To be “directly connected” with a trade or business, an item of deduction must have a proximate and primary relationship to the carrying on of the unrelated trade or business generating the gross income.
See
§ 1.512(a)-1(a). Expenses, depreciation, and similar items attributable solely to the conduct of an unrelated trade or business are proximately and primarily related to that trade or business and qualify to reduce income from such trade or business under section 512(a)(1) to the extent such items meet the requirements of sections 162 (trade or business expenses), 167 (depreciation), and other relevant provisions. To the extent that an exempt organization may have items of deduction that are shared between an exempt activity and an unrelated trade or business, § 1.512(a)-1(c) provides special rules for allocating such expenses. For example, if facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, then expenses, depreciation, and similar items attributable to such facilities must be allocated between the two uses on a reasonable basis.
See
§ 1.512(a)-1(c).
3

3
The same method used for allocating expenses in determining taxable income must also be used when determining whether an activity is conducted with the intent to profit, and thus (as discussed further in section 5.b.iv of this preamble) whether such activity is a trade or business.
Portland Golf Club
v.
Commissioner,
497 U.S. 154, 171 (1990) (stating that “in demonstrating the requisite profit motive, Portland Golf must employ the same method of allocating fixed expenses as it uses in calculating its actual loss”).

The allocation issues under section 512(a)(1) are also relevant under section 512(a)(6) because an exempt organization with more than one unrelated trade or business must not only allocate indirect expenses among exempt and taxable activities as described in § 1.512(a)-1(c) but also among separate unrelated trades or businesses. Accordingly, Notice 2018-67 stated the Treasury Department and the IRS are considering modifying the underlying reasonable allocation method in § 1.512(a)-1(c) and providing specific standards for allocating expenses relating to dual use facilities and the rules under section 512(a)(6). Notice 2018-67 requested comments regarding possible rules or defined standards for the allocation of indirect expenses between separate unrelated trades or businesses for purposes of calculating UBTI under section 512(a)(6)(A), and regarding what allocation methods should be considered “reasonable.”

The three commenters addressing allocation methods generally recommended retaining the current “any reasonable method” approach. Nonetheless, one of these commenters recommended that the Treasury Department and the IRS adopt existing cost allocation rules set forth by the OMB, referred to as the Uniform Administrative Requirements, Cost Principles, and Audit Requirements for Federal Awards (2 CFR 200), and by the Financial Accounting Standards Board in the Accounting Standard Update 2016-14, both of which require allocations to be made “on a rational, reasonable, and objective basis across functional expense categories.” Another commenter recommended adopting accounting methods specific to social club activities, such as a golf.

The Treasury Department and the IRS are concerned that permitting allocation methods based solely on reasonableness is difficult for the IRS to administer and may not provide certainty for taxpayers. Whether an allocation method is “reasonable” depends on all the facts and circumstances.
See Rensselaer Polytechnic Institute
v.
Commissioner,
79 T.C. 967 (1982),
aff'd
732 F.2d 1058 (2d Cir. 1984) (finding an allocation method based on actual use to be “reasonable” within the meaning of § 1.512(a)-1(c)). The Treasury Department and the IRS continue to consider the allocation issue and intend to publish a separate notice of proposed rulemaking providing further guidance on this issue. Until publication of a separate notice of proposed rulemaking, these proposed regulations incorporate the existing allocation standard in § 1.512(a)-1(c), which provides that an exempt organization must allocate deductions on a reasonable basis between separate unrelated trades or businesses. The proposed regulations also provide that the use of the unadjusted gross-to-gross method is not a reasonable allocation method under the general allocation rule and as incorporated for section 512(a)(6) purposes (see section 1.d.iii of this preamble).

ii. State and Local Taxes and Tax Preparation Fees

At least one commenter requested guidance on the deduction of certain general expenses. This commenter recommended that tax return preparation fees be permitted as a deduction after calculation of total UBTI under section 512(a)(6)(B). The commenter argued that such expenses should not be allocated between separate unrelated trades or businesses because such expenses pertain to all the exempt organization's activities—related and unrelated.

As previously discussed, deductions are permitted under section 512(a)(1) and (3) only if two conditions are met: (1) The deduction is allowed under chapter 1; and (2) in the case of section 512(a)(1), the deduction is directly connected with the carrying on of such separate unrelated trade or business, or, in the case of section 512(a)(3), the deduction is directly connected with the production of the gross income (excluding exempt function income). Accordingly, an exempt organization may deduct only tax return preparation fees that are directly connected with a separate unrelated trade or business, in the case of an organization subject to section 512(a)(1), or that are directly connected with the production of the gross income (excluding exempt function income), in the case of an organization subject to section 512(a)(3). If such fees are directly connected with more than one separate unrelated trade or business or are also attributable to the exempt organization's related activities (or exempt function income in the case of an organization subject to section

512(a)(3)), the exempt organization must allocate such expenses as discussed in section 4.d.i of this preamble.
See
§ 1.512(a)-1(c). Nothing in section 512(a)(6)(B) permits either the deduction of expenses that are not otherwise deductible in calculating UBTI or the deduction of expenses after calculation of total UBTI. Thus, the Treasury Department and the IRS do not adopt this comment.

One commenter also suggested that state income taxes not directly connected with any separate unrelated trade or business resulting from the increase in UBTI under section 512(a)(7) be permitted as a deduction after calculation of total UBTI under section 512(a)(6)(B). With the repeal of section 512(a)(7), the Treasury Department and the IRS expect that exempt organizations are no longer subject to state income taxes that are not directly connected with the carrying on of a separate unrelated trade or business. If this is not the case, the Treasury Department and the IRS request examples of such state income taxes.

iii. The Unadjusted Gross-to-Gross Method Is Unreasonable

The IRS has previously indicated that it will not litigate the reasonableness of the allocation method in
Rensselaer
pending revision of the Treasury regulations. 732 F.2d 1058,
action on dec.,
1987-014 (Jun. 18, 1987). However, regarding facilities or personnel that are used both to carry on exempt activities and to conduct unrelated trade or business activities or more than one separate unrelated trade or business, the Treasury Department and the IRS have concluded that allocation of expenses, depreciation, and similar items using an unadjusted gross-to-gross method is not reasonable. In general, a gross-to-gross method of allocation uses a ratio of gross income from an unrelated trade or business activity over the total gross income from both unrelated and related activities generating the same indirect expenditures. The percentage resulting from this ratio is used to determine the percentage of the shared costs attributable to the unrelated trade or business activity (or activities).

In some circumstances, the provision of a good or service can be both related and unrelated depending on to whom the good or service is offered. For example, with respect to social clubs, the provision of goods and services to members is an exempt function whereas the provision of the same goods and services to nonmembers is a nonexempt function. Another example is a school that operates a ski facility for use in its physical education program and for recreational use by its students and the general public. Rev. Rul. 78-98, 1978-1 C.B. 167. If the social club charges nonmembers a higher price than it charges members for the same good or service or if the school charges the general public more for slope and ski lift fees than it charges its students, the gross-to-gross ratio will increase, resulting in more indirect expenses being allocated to the unrelated activity. However, no difference likely exists in the cost of providing the good or service to members versus nonmembers or in the cost of providing the ski slopes and lifts to students versus the public. Accordingly, the failure to adjust the price of the good or service offered to nonmembers or the general public for purposes of determining the allocation of indirect expenses (that is, using an unadjusted gross-to-gross method) overstates the percentage of the indirect expenses that should be allocated to the unrelated activities.
See Portland Golf,
497 U.S. at 157 fn. 4 (indicating that a system where the taxpayer “charges nonmembers higher prices for food and drink than members are charged, even though nonmembers' meals presumably cost no more to prepare and serve” seems likely to “[overstate] the percentage of fixed costs properly attributable to nonmember sales”).

When an organization charges different prices for the same good or service depending on whether the offering of the good or service is a related or unrelated activity, then such organization should adjust the per “unit” price of the good or service of the related activity to that of the unrelated activity (or activities) for the ratio created by the gross-to-gross method to appropriately account for the percentage of indirect expenses attributable to the unrelated activity. Failing to make this adjustment does not appropriately account for the portion of indirect expenses attributable to an unrelated activity and is therefore an unreasonable method for allocating expenditures under § 1.512(a)-1(c). Accordingly, the proposed regulations provide that the unadjusted gross-to-gross method is not reasonable, whether under the general allocation rule or as incorporated for section 512(a)(6) purposes.

The Treasury Department and the IRS request comments regarding whether any other allocation methods should be considered unreasonable and the methods or rules that could be adopted instead of a reasonableness standard for allocations both between related and unrelated activities and between two or more separate unrelated trades or businesses.

2. Activities in the Nature of Investments

Several commenters expressed concern regarding the use of the NAICS codes to identify investment activities as one or more separate unrelated trades or businesses. One commenter noted that a partnership is not required to report the NAICS codes for all the trades or businesses in which it engages on the Schedule K-1 (Form 1065), “Partner's Share of Income, Deductions, Credits, etc.,” provided to its partners. Another commenter expressed concern that the NAICS codes lacked specificity for purposes of sufficiently identifying an exempt organization's investment activities. Therefore, two commenters suggested that an exempt organization's investment activities be identified separately from other activities identified using the NAICS codes.

Consistent with Notice 2018-67, the proposed regulations generally permit the aggregation of the investment activities specifically listed in the proposed regulations for purposes of section 512(a)(6) to mitigate the burden on exempt organizations, particularly those with interests in multi-tier partnerships. However, under the proposed regulations, investment activities are not identified using NAICS 2-digit codes. Specifically, the proposed regulations provide that NAICS 2-digit codes are used to identify separate unrelated trades or businesses except to the extent provided in other paragraphs of the proposed regulations. Under the proposed regulations, an exempt organization's investment activities, as well as the separate unrelated trades or businesses discussed in sections 3 and 4 of this preamble, are identified as described in the proposed regulations and reported as described in the forms and instructions (see section 8 of this preamble).

a. Investment Activities Are Treated as a Separate Unrelated Trade or Business for Purposes of Section 512(a)(6)

As a general matter, a number of commenters suggested that the Treasury Department and the IRS should not treat an exempt organization's investment activities as an unrelated trade or business, and therefore the income and losses from these activities should not be considered for purposes of applying section 512(a)(6). The Treasury Department and the IRS have concluded that the structure and purposes of sections 511 through 514 indicate that an exempt organization's investment activities should be treated as a separate unrelated trade or business for purposes of section 512(a)(6). Section 512(a)(1)

provides that UBTI means the gross income derived by an exempt organization from any unrelated trade or business regularly carried on by it. Further, section 512(a)(1) provides that an exempt organization excludes from the calculation of UBTI the amounts described in section 512(b)(1), (2), (3), and (5)—that is, dividends, interest, annuities, etc.; royalties; rents; and capital gains. If an exempt organization's investment activities were not an unrelated trade or business, exclusion of certain amounts under section 512(b), such as capital gains (and losses) under section 512(b)(5), would appear to be unnecessary. Furthermore, other income that an exempt organization may consider “investment income”—such as unrelated debt-financed income—is treated as “derived from an unrelated trade or business” under other paragraphs of section 512(b)—including section 512(b)(4). The application of section 512(a)(6) to income included in UBTI under section 512(b)(4), (13), or (17) is discussed in more detail in section 3 of this preamble.

Some commenters cited
Higgins
v.
Commissioner,
312 U.S. 212 (1941), to support the position that an exempt organization's investment of its own assets is not a trade or business. However,
Higgins
is not relevant under sections 511 through 514 because it applies to individuals, not corporations or trusts. For the taxable years involved in
Higgins,
a deduction was allowed for all ordinary and necessary expenses of carrying on a trade or business, but a deduction was not allowed for personal, living, or family expenses. Congress responded to
Higgins
by enacting what is now section 212(1) to allow individuals to deduct all ordinary and necessary expenses incurred in the production or collection of income.
Estate of Rockefeller
v.
Commissioner,
762 F.2d 264, 266 n.3 (2d Cir. 1985). Section 212 applies only to individuals. Corporations or trusts may deduct only “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” under section 162. Thus, no deduction for expenses directly connected with investment activities would be permitted to a corporation or trust unless its investment activities are a part of a trade or business within the meaning of section 162.

However, the Treasury Department and the IRS recognize that exempt organizations have UBTI under sections 511 through 514 from activities engaged in with an intent to make an investment rather than with the intent to actively participate in any of the unrelated trade or business activities generating the UBTI. Accordingly, Notice 2018-67 stated that, as a matter of administrative convenience, the proposed regulations would treat an exempt organization's investment activities as one trade or business for purposes of section 512(a)(6)(A) in order to permit the exempt organization to aggregate gross income and directly connected deductions from possibly multiple separate unrelated trades or businesses. After publication of Notice 2018-67, the Joint Committee on Taxation (JCT) confirmed that “it is intended that the Secretary consider whether it would be appropriate in certain cases to permit an organization that maintains an investment portfolio to treat multiple investment activities as one unrelated trade or business.” Staff of the Joint Committee on Taxation, General Explanation of Public Law 115-97 (December 2018), at 293 (General Explanation). Consistent with Notice 2018-67 and the General Explanation, the proposed regulations provide that an exempt organization's various investment activities, as exclusively listed therein, are treated as a separate unrelated trade or business for purposes of section 512(a)(6)(A) and the proposed regulations.

b. Exclusive List of “Investment Activities”

Notice 2018-67 did not define the term “investment activities” but rather requested comments regarding the scope of the activities, both investment partnership interests or other investment activities, that should be included in the category of “investment activities” for purposes of section 512(a)(6). Some commenters suggested that the term “investment activities” include all passive income. Some of these commenters specifically suggested using the definition of “material participation” in section 469 as a method to identify “investment activities.” However, most commenters addressing this issue suggested that the term “investment activities” should include activities that give rise to amounts included as: An item of gross income derived from an unrelated trade or business under section 512(b)(4) (debt-financed property), (13) (certain amounts received from controlled entities), and (17) (certain amounts derived from foreign corporations); gross income (or loss) from a partnership that is not directly or indirectly controlled by the exempt organization; and, with respect to controlled partnerships, an item of gross income derived from an unrelated trade or business under section 512(b)(4), (13), and (17).

In drafting these proposed regulations, the Treasury Department and the IRS considered whether to provide a general definition of the term “investment activities.” However, even though other areas of the Code make a distinction between “active” and “passive” activities, those distinctions are not applicable for purposes of sections 511 through 514. Section 512(c) applies regardless of whether the exempt organization is an active or passive participant in the unrelated trade or business of the partnership or whether it is a general or limited partner. Rev. Rul. 79-222;
Service Bolt & Nut Co.
v.
Commissioner,
724 F.2d 519, 523-24 (6th Cir., 1983),
affg,
78 T.C. 812 (1982);
see also

Leila G. Newhall Unitrust
v.
Commissioner,
105 F.3d 482 (9th Cir. 1997),
affg,
104 T.C. 236 (1995) (following
Service Bolt & Nut,
724 F.2d 519). Thus, the Treasury Department and the IRS do not believe that use of the criteria for finding “material participation” under section 469 is appropriate in applying section 512(a)(6).

Rather, the proposed regulations provide an exclusive list of an exempt organization's investment activities that can be treated as one separate unrelated trade or business for purposes of section 512(a)(6). Under the proposed regulations, for most exempt organizations, such investment activities are limited to: (i) Qualifying partnership interests (see section 2.d of this preamble); (ii) debt-financed properties (see section 3.a of this preamble); and (iii) qualifying S corporation interests (see section 4.a of this preamble). As discussed in section 5.b.i of this preamble, the qualifying partnership rules do not apply to social clubs described in section 501(c)(7). However, for exempt organizations subject to section 512(a)(3) (including social clubs), the proposed regulations clarify that UBTI from the investment activities of such organizations includes certain additional amounts (see section 5.a of this preamble).

The Treasury Department and the IRS will continue to consider whether the term “investment activities” can be defined more generally in a manner that is administrable and consistent with the legislative intent of section 512(a)(6). The Treasury Department and the IRS request comments regarding the specific factors that should be considered when determining whether an activity is an investment activity for purposes of section 512(a)(6).

c. Partnership Interests

With respect to partnership interests, the Treasury Department and the IRS stated in Notice 2018-67 that the category of “investment activities” for purposes of section 512(a)(6) should include only partnership interests in which the exempt organization does not significantly participate in any partnership trade or business. Some commenters suggested including in this category partnerships over which the exempt organization has no control, which is discussed in more detail in section 2.d of this preamble.

Other commenters suggested that this category include all limited partnerships or limited liability companies (LLCs) in which the exempt organization is a non-managing member (regardless of the exempt organization's percentage interest or other participation in the partnership). The Treasury Department and the IRS decline to adopt this comment because of the variation in state law for determining non-managing member equivalent interests and the administrative burden that reliance on state law places on the IRS. Nonetheless, as discussed in section 2.d.iii.B of this preamble, the Treasury Department and the IRS recognize that there may be rights or actions permitted by state law that are normal and routine and that do not indicate any measurable influence or control over a partnership. Accordingly, the Treasury Department and the IRS request comments on whether certain permitted rights or actions should be disregarded in determining whether a partnership interest is a qualifying partnership interest. In addition, the proposed regulations clarify that any partnership in which an exempt organization is a general partner for any federal tax purpose is not a qualifying partnership interest within the meaning of the proposed regulations, regardless of the exempt organization's percentage interest.

d. Qualifying Partnership Interests

Pending publication of proposed regulations, the interim rule described in Notice 2018-67 permitted an exempt organization to aggregate its UBTI from certain partnership interests with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships (qualifying partnership interest).
See
section 6.01(2) of Notice 2018-67. Additionally, the interim rule permitted the aggregation of any qualifying partnership interest (QPI) with all other QPIs, resulting in the treatment of the aggregate group of QPIs as a single trade or business for purposes of section 512(a)(6)(A).
Id.

Although some commenters suggested retaining the interim rule as described in Notice 2018-67, the majority of commenters appeared to support retention of the interim rule but made suggestions regarding possible revisions that potentially could reduce any administrative burden associated with the rule. Consistent with these comments, the proposed regulations retain the interim rule with the modifications described in the following sections of this preamble.

i. Designation of a QPI

Like Notice 2018-67, the proposed regulations permit, but do not require, an organization to aggregate its UBTI from QPIs.
See
section 6.01(2) of Notice 2018-67. However, the proposed regulations add that, once an organization designates a partnership interest as a QPI (in accordance with forms and instructions), it cannot thereafter identify the trades or businesses conducted by the partnership that are unrelated trades or businesses with respect to the organization using NAICS 2-digit codes unless and until the partnership interest is no longer a QPI. For example, if an organization has a partnership interest that is a QPI and the organization designates that partnership interest as a QPI on its Form 990-T, the organization cannot, in the next taxable year, identify the trades or businesses of the partnership that are unrelated trades or businesses with respect to the organization using NAICS 2-digit codes. However, if in a future taxable year, the organization's partnership interest is no longer a QPI, then the organization would be required to identify the trades or business of the partnership that are unrelated trades or businesses with respect to the organization using NAICS 2-digit codes.

A partnership interest is a QPI if it meets the requirements of either the de minimis test (discussed in section 2.d.ii of this preamble) or the control test (discussed in section 2.d.iii of this preamble).

ii. The De Minimis Test

Both Notice 2018-67 and the proposed regulations provide that a partnership interest is a QPI that meets the requirements of the de minimis test if the exempt organization holds directly no more than 2 percent of the profits interest and no more than 2 percent of the capital interest.
See
section 6.02(1) of Notice 2018-67. As noted by several commenters, the 2 percent threshold for the de minimis test is consistent with the de minimis test under section 4943, which provides that a private foundation does not have excess business holdings in any corporation in which it (together with certain related private foundations described in section 4946(a)(1)(H)) owns not more than 2 percent of the voting stock and not more than 2 percent in value of all outstanding shares of all classes of stock. The Treasury Department and the IRS chose not to cross-reference the section 4943 de minimis test because that section applies only to private foundations. Nonetheless, because Congress adopted a 2 percent de minimis test under section 4943, the Treasury Department and the IRS consider a 2 percent threshold to be appropriate for purposes of the de minimis test in the proposed regulations.

However, the proposed regulations make two changes to the de minimis test provided in Notice 2018-67 to improve administrability and to provide more appropriate relief. First, as discussed in section 2.d.iv of this preamble, an exempt organization is no longer required to combine certain related interests when determining whether a partnership interest meets the requirements of the de minimis test. Second, in response to comments that the interim rule should apply to lower-tier partnerships, the proposed regulations provide that, if an exempt organization does not control a partnership in which the exempt organization holds a direct interest (directly-held partnership interest) but that directly-held partnership interest is not a QPI because the exempt organization holds more than 20 percent of the capital interest, any partnership in which the exempt organization holds an indirect interest through the directly-held partnership interest (indirectly-held partnership interest) may be a QPI if the indirectly-held partnership interest meets the requirements of the de minimis test (look-through rule). Accordingly, the proposed regulations permit (but do not require) an exempt organization to aggregate the UBTI from some indirectly-held QPIs with its directly-held QPIs. However, the look-through rule does not apply to indirectly-held QPIs that do not meet the requirements of the de minimis test but may meet the requirements of the control test.

For example, if an exempt organization directly holds 50 percent of the capital interests of a partnership that it does not control and the directly-held partnership holds 4 percent of the capital and profits interests of lower-tier partnership A and 10 percent of the

capital and profits interests of lower-tier partnership B, the exempt organization can aggregate its interest in lower-tier partnership A with its other QPIs because the exempt organization indirectly holds 2 percent of the capital and profits interests of lower-tier partnership A (4 percent × 50 percent = 2 percent). However, the exempt organization may not aggregate its interest in lower-tier partnership B with its QPIs because the exempt organization indirectly holds 5 percent (10 percent × 50 percent) of the capital and profits interest of lower-tier partnership B, which does not meet the requirements of the de minimis test.

If a directly-held partnership interest is not a QPI, the general principles of section 512(c) apply and the exempt organization is required to identify the trades or businesses conducted by the directly-held partnership, and any indirectly-held partnerships, that are unrelated trades or businesses with respect to the exempt organization. The Treasury Department and the IRS expect that permitting an exempt organization to aggregate any indirectly-held partnership interests that meet the requirements of the de minimis test with all other QPIs will reduce the administrative burden on exempt organizations because there will be no need to identify each trade or business conducted by such indirectly-held partnership. However, the Treasury Department and the IRS request comments regarding the administrability of permitting the aggregation of indirectly-held partnership interests that meet the requirements of the de minimis test.

iii. The Control Test

Notice 2018-67 stated that a partnership interest is a QPI that meets the requirements of the control test if the exempt organization (i) directly holds no more than 20 percent of the capital interest; and (ii) does not have control or influence over the partnership.
See
section 6.03(1) of Notice 2018-67.

A. Percentage Interest

Numerous commenters made recommendations regarding the first prong of the control test, most of which recommend increasing the percentage threshold to 50 percent to conform with the definition of control in section 512(b)(13). Multiple commenters suggested that the percentage control requirement be eliminated entirely.

The proposed regulations retain the 20 percent threshold used in Notice 2018-67. The Treasury Department and the IRS intend the percentage threshold to be a proxy to identify partnership interests in which the exempt organization does not significantly participate in any partnership trade or business and therefore may appropriately be considered an investment activity for purposes of section 512(a)(6). The 20 percent threshold is consistent with at least one other administrative exception created for certain investment activities.
See
section 731(c)(3)(C)(i) & § 1.731-2(e). Accordingly, the proposed regulations treat a 20 percent interest in a partnership over which the exempt organization partner has no control (see section 2.d.iii.B of this preamble) as a part of the exempt organization's investment activities. However, as with the de minimis test, an exempt organization is no longer required to combine certain related interests when determining whether a partnership interest meets the 20 percent threshold under the control test (see section 2.d.iv of this preamble).

The Treasury Department and the IRS recognize that an exempt organization may have more than 20 percent of the capital interests of a partnership but the exempt organization may consider that partnership interest to be part of its investment activities raising funds for its exempt activities. However, as discussed in section 2.b of this preamble, the proposed regulations do not provide a general definition of the term “investment activities” such that a non-QPI could be aggregated with the exempt organization's other investment activities for purposes of section 512(a)(6). While the addition of the look-through rule to the de minimis test in these proposed regulations may result in the aggregation of some of the lower-tier partnership interests of a directly-held non-QPI, an exempt organization's investment intent is not sufficient to treat the overall non-QPI as part of its investment activities.

At least two commenters suggested that the capital interests in a partnership do not indicate control over a partnership. The Treasury Department and the IRS understand that a partner's percentage interest in the capital interests of a partnership does not necessarily correlate with the partner's ability to control the partnership. However, the Treasury Department and the IRS have concluded that a combination of an exempt organization's percentage capital interest in a partnership and the exempt organization's ability to control the partnership are an appropriate administrative proxy for determining whether a partnership interest is an investment activity. The use of a percentage interest, in addition to the definition of “control” discussed in section 2.d.iii.B of this preamble, provides a bright line for the evaluation of partnership interests that may be investment activities. Furthermore, because an exempt organization's percentage profits interest may change throughout the year, the proposed regulations continue to consider only an exempt organization's capital interest in a partnership for purposes of the control test.

B. Definition of “Control”

Notice 2018-67 provided that all facts and circumstances are relevant for determining whether an exempt organization has control or influence over a partnership.
See
section 6.03(3) of Notice 2018-67. Notice 2018-67 then provided three specific circumstances in which an exempt organization has control or influence.
Id.
Commenters generally appeared to support the inclusion of a facts and circumstances test. Nonetheless, numerous commenters suggested revisions to what it means for an exempt organization to have influence or control over a partnership.

First, Notice 2018-67 provided that an exempt organization has control or influence if the exempt organization may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership. Several commenters recommended that the proposed regulations clarify that the right to vote for the appointment or removal of a general partner or managing member, the ability to appoint representatives to investor committees or advisory committees, and the right to approve the selection or removal of a general partner or managing member do not evidence influence or control. These commenters explained that these rights help ensure that the general partner cannot alter a partnership without the consent of the limited partners. Similarly, other commenters requested that the proposed regulations clarify that an exempt organization will not be deemed to have influence or control over a partnership if it exercises its rights or takes actions that it is permitted to take under state law while maintaining its limited liability status in a partnership.

Second, Notice 2018-67 provided that an exempt organization has control or influence over a partnership if any of the exempt organization's officers, directors, trustees, or employees have rights to participate in the management of the partnership or conduct the partnership's business at any time, or if

the exempt organization has the power to appoint or remove any of the partnership's officers, directors, trustees, or employees. One commenter stated that the presence of these rights or powers does not necessarily illustrate control. Another commenter suggested that this rule is overly restrictive and will cause many partnership interests in which an exempt organization has no influence or control to fail to meet the requirements of the control test. This commenter stated that many exempt organizations have governing board members that also work in the investment management industry and may participate in conducting the business of a partnership in which the exempt organization invests. The commenter explained that these individuals' expertise in financial management is essential for the prudent management of an exempt organization's investments. The commenter argued that a general rule based on facts and circumstances is sufficient to address situations in which an exempt organization exercises “excessive” influence or control over a partnership such that it should not be considered a QPI.

The proposed regulations retain the control rule described in Notice 2018-67 with minor modifications to address the comments described above. In particular, the proposed regulations remove the term “influence” so that the second prong of the control test provides that, if the exempt organization has 20 percent or less of the capital interests, a partnership interest is a QPI that meets the requirements of the control test if the exempt organization does not control the partnership. Consistent with Notice 2018-67, the proposed regulations provide that all the facts and circumstances are relevant for determining whether an exempt organization controls a partnership. The proposed regulations clarify that the partnership agreement is among the facts and circumstances that may be considered when making a determination of control.

The proposed regulations also list certain specific circumstances that evidence control, focusing on four discrete rights or powers. Two circumstances focus on the exempt organization's ability to perform certain actions on its own. Specifically, the proposed regulations provide that an exempt organization controls a partnership if the exempt organization, by itself, may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership or has the power to appoint or remove any of the partnership's officers or employees or a majority of directors. The remaining two circumstances focus on whether any of the exempt organization's officers, directors, trustees, or employees have rights to participate in the management of the partnership at any time or to conduct the partnership's business at any time. No exception is provided for certain professionals that may serve on the boards of both the exempt organization and partnerships in which the exempt organization is a partner.

The Treasury Department and the IRS recognize that, although these rights or powers indicate control in some situations, other facts and circumstances may tip the scale the other way. Accordingly, the Treasury Department and the IRS request comments regarding whether all these rights or powers should be weighted the same or whether there are certain circumstances in which such right or power would never indicate control.

iv. Combining Related Interests

Both the de minimis test and the control test in Notice 2018-67 required an exempt organization to own less than a certain percentage of the profits and capital interests in a partnership.
See
sections 6.02(1) (de minimis test) and 6.03(1) (control test) of Notice 2018-67. In determining the exempt organization's ownership percentage, both the de minimis test and the control test required the exempt organization to combine certain related interests (aggregation rule).
Id.
The aggregation rule in section 6.02(2)(b)(i) of Notice 2018-67 provided that, when determining an exempt organization's percentage partnership interest, the interest of a disqualified person (as defined in section 4958(f)), a supporting organization (as defined in section 509(a)(3)), or a controlled entity (as defined in section 512(b)(13)) in the same partnership would be taken into account.
See
section 6.02(2)(b)(ii) through (iv) of Notice 2018-67.

Most commenters suggested that the aggregation rule is overly burdensome and requested that it be removed. Commenters noted that many public charity boards have numerous members and argued that verifying the board members' ownership percentages, after taking into account other related interests, for every partnership interest that generates UBTI would be unreasonable, if not impossible. Additionally, these commenters stated that the exempt organization cannot usually obtain information about other partners from the partnerships in which it holds interests because of confidentiality agreements.

If the aggregation rule is retained, commenters recommended several revisions. First, two commenters suggested eliminating the aggregation rule for the de minimis test. Next, a commenter suggested only requiring aggregation of interests owned by controlled entities and persons with direct control over the exempt organization's investment decisions. Additionally, another commenter would limit aggregation with interests owned by controlled entities to those interests owned by Type I and II supporting organizations described in section 509(a)(3)(B)(i) and (ii) and exclude interests owned by Type III supporting organizations described in section 509(a)(3)(B)(iii). Finally, another commenter suggested requiring aggregation with interests owned by controlled entities but not interests owned by persons or organizations that are not controlled by the exempt organization.

The proposed regulations retain a modified aggregation rule to address situations in which an exempt organization may control a partnership through the aggregation of interests. The aggregation rule in the proposed regulations differs from the aggregation rule in Notice 2018-67 in two ways. First, the aggregation rule in the proposed regulations applies only for purposes of the control test and not for purposes of the de minimis test. Second, the proposed regulations do not require an exempt organization to take into account the interests of disqualified persons when determining the exempt organization's percentage interest in a partnership for purposes of the control test.

The proposed regulations adopt other aspects of the aggregation rule from Notice 2018-67 without change. In particular, the proposed regulations include the definitions of “supporting organization” and “controlled entity” used in Notice 2018-67, which cross-referenced sections 509(a)(3) and 512(b)(13)(D), respectively. Additionally, the proposed regulations provide that, when determining an exempt organization's percentage interest in a partnership for purposes of the control test, the interests of a supporting organization or a controlled entity in the same partnership will be taken into account. However, the Treasury Department and the IRS will continue to consider whether the aggregation of the interests of supporting organizations is appropriate in the circumstance in which the exempt organization is a supported

organization that has little to no control over its supporting organizations.

v. Reliance on Schedule K-1 (Form 1065)

Notice 2018-67 provided that, in determining the exempt organization's percentage interest in a partnership, the exempt organization may rely on the Schedule K-1 (Form 1065) (or its successor) it receives from the partnership. Commenters requested various revisions to the Schedule K-1 (Form 1065) to assist in the reporting process. The Treasury Department and the IRS will consider revisions to the Schedule K-1 (Form 1065). Otherwise, the proposed regulations continue to permit reliance on Schedule K-1 (Form 1065) if the form lists the exempt organization's percentage profits interest or its percentage capital interest, or both, at the beginning and end of the year. However, the proposed regulations clarify that the exempt organization may not rely on the form to the extent that any information about the exempt organization's percentage interest is not specifically provided. For example, if the Schedule K-1 (Form 1065) an exempt organization receives from a partnership lists the exempt organization's percentage capital interest at the beginning and end of the year but lists its profits interest as “variable,” the exempt organization may rely on the form only with respect to its percentage capital interest.

vi. Additional Recommended Changes

Commenters suggested additional modifications to the de minimis and control tests, including phase-in and grace periods to address changes in an exempt organization's percentage interest that are beyond the exempt organization's control. Two commenters requested that an exempt organization be permitted up to 90 days to reduce its interest in a partnership in order to satisfy the requirements of the de minimis test if the increase in interest was because of another partner's withdrawal or percentage reduction. Another commenter suggested that, if a partnership interest met the requirements of either the de minimis test or the control test in a taxable year, the partnership interest should continue to meet those requirements in the following taxable years if the exempt organization's percentage interest changed through no action of the exempt organization partner.

The proposed regulations do not adopt any of these recommended changes because the de minimis and control tests are rules of administrative convenience. Allowing greater interests due to other actions would require other safeguards and limitations that would complicate the rule and place additional administrative burdens on exempt organizations and the IRS. Nevertheless, the Treasury Department and the IRS recognize that an exempt organization may not be aware of changes in its partnership interest until it receives a Schedule K-1 (Form 1065) from the partnership at the end of the partnership's taxable year. In such a circumstance, it may be appropriate to permit a higher percentage interest in taxable years in which the increase in an exempt organization's percentage interest during a taxable year is the result of the actions of other partners. Accordingly, the Treasury Department and the IRS request comments regarding whether permitting a higher percentage interest in taxable years in which the increase occurs as the result of the actions of other partners would address these commenters' concerns.

e. Transition Rule

Pending publication of proposed regulations, the transition rule in Notice 2018-67 permitted an exempt organization to treat each partnership interest acquired prior to August 21, 2018, that failed to meet the requirements of either the de minimis test or the control test as one trade or business for purposes of section 512(a)(6), regardless of whether there was more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships.
See
section 6.04 of Notice 2018-67.

Many commenters asserted that the transition rule should apply to any partnership interest held by an exempt organization regardless of the date acquired. However, in the case of a partnership that conducts more than one trade or business that is a separate unrelated trade or business with respect to the exempt organization, applying the transition rule to all partnership interests and treating each non-QPI as one trade or business would undermine the purpose of section 512(a)(6) by allowing the gains from one unrelated trade or business to offset the losses from another unrelated trade or business. Accordingly, the Treasury Department and the IRS do not accept this comment.

Other commenters suggested that the proposed regulations should clarify that, if an exempt organization acquired a partnership interest before August 21, 2018, changes in the exempt organization's percentage interest would not affect the availability of the transition rule. Accordingly, the proposed regulations clarify that a partnership interest acquired prior to August 21, 2018, will continue to meet the requirement of the transition rule even if the exempt organization's percentage interest changes on or after August 21, 2018.

The proposed regulations also include two additions to the transition rule. First, the proposed regulations permit an exempt organization to rely on the transition rule only until the first day of the organization's first taxable year beginning after the date these proposed regulations are published as final regulations (transition period). Second, the proposed regulations provide that an exempt organization may apply either the transition rule or the look-through rule, but not both, to a partnership interest that meets the requirements for both rules. During the transition period, the exempt organization must determine how a partnership interest to which it chose to apply the transition rule will be treated under the final regulations. The Treasury Department and the IRS request comments regarding whether any additional transitional relief is necessary.

3. Inclusions of Income Derived From an Unrelated Trade or Business Under Section 512(b)(4), (13), and (17)

Section 512(b)(4), (13), and (17) require the inclusion of certain income as items of gross income derived from an unrelated trade or business if such income is unrelated debt-financed income, a specified payment from controlled entities, or certain insurance income derived from a controlled foreign corporation, respectively. In Notice 2018-67, the Treasury Department and the IRS explained that, in the absence of section 512(b)(1), (2), (3), and (5), the income described in these sections would be included in the calculation of UBTI to the extent that such amounts are “gross income derived by any organization from any unrelated trade or business . . . regularly carried on by it” under section 512(a)(1). Accordingly, the Treasury Department and the IRS stated that no distinction existed between “gross income derived by any organization from any unrelated trade or business . . . regularly carried on by it” within the meaning of section 512(a)(1) and amounts included “as an item of gross income derived from an unrelated trade or business” under section 512(b)(4), (13), and (17).

However, the Treasury Department and the IRS recognized that some interpretations of section 512(a)(6) might impose a significant burden on exempt organizations required to include certain income in UBTI under section 512(b)(4), (13), or (17), and,

consequently, that aggregating income included in UBTI under these sections may be appropriate in certain circumstances. In Notice 2018-67, the Treasury Department and the IRS requested comments regarding the treatment under section 512(a)(6) of income that is not from a partnership, but that is included in UBTI under section 512(b)(4), (13), and (17).

A few commenters disagreed with the statement that there is “no distinction between `gross income derived by any organization from any unrelated trade or business . . . regularly carried on by it' under section 512(a)(1) and amounts included in UBTI `as an item of gross income derived from an unrelated trade or business' under section 512(b)(4), (13), and (17).” These commenters argued that amounts included as items of gross income from an unrelated trade or business under section 512(b)(4), (13), and (17) should not be subject to section 512(a)(6) because such amounts are treated as income from investment activities and not as gross income from a trade or business.

As discussed in section 2.a of this preamble, investment activities are treated as a separate unrelated trade or business for purposes of section 512(a)(6). Furthermore, section 512(b)(4), (13), and (17) each provide that income described in the provision is income derived from an unrelated trade or business. Accordingly, amounts included in UBTI under section 512(b)(4), (13), and (17) contribute to the determination of whether an organization has more than one unrelated trade or business and thus is subject to section 512(a)(6). After considering the comments received and the legislative history of each section, the Treasury Department and the IRS propose the following treatment of amounts included in UBTI under section 512(b)(4), (13), and (17) for purposes of section 512(a)(6).

a. Unrelated Debt-Financed Income

In the case of debt-financed property (as defined in section 514), section 512(b)(4) requires an exempt organization to include, as an item of gross income from an unrelated trade or business, any unrelated debt-financed income, determined under section 514, with respect to such debt-financed property, even if an amount received with respect to the debt-financed property would ordinarily be excluded from the calculation of UBTI under section 512(b)(1), (2), (3), or (5). Section 514(b)(1) defines the term “debt-financed property” as any property that is held to produce income and with respect to which there is acquisition indebtedness. Section 1.514(b)-1(a) clarifies that property held to produce income includes rental real estate, tangible personal property, and corporate stock. Section 1.514(a)-1(a) provides that the calculation of debt-financed taxable income is made on a property-by-property basis. Thus, as stated in Notice 2018-67, one interpretation of sections 512(b)(4) and 514 and the regulations thereunder could require each debt-financed property to be treated as a separate unrelated trade or business under section 512(a)(6).

However, the amounts excluded from the calculation of UBTI under section 512(b)(1), (2), (3), and (5) that are included in UBTI if subject to acquisition indebtedness include dividends, interest, annuities, royalties, rents, and capital gains. As acknowledged in section 2.a of this preamble, dividends, interest, annuities, royalties, rents, and capital gains generally are income from investment activities. Additionally, section 514 generally does not apply to any property to the extent that the income from such property is taken into account in computing the gross income of any unrelated trade or business (except in the case of capital gains from such property that would be excluded under section 512(b)(5)).
See
section 514(b)(1)(B). Accordingly, the Treasury Department and the IRS agree with commenters that debt-financed properties (as defined in section 514) generally are held for investment purposes. Therefore, to reduce the reporting burden on exempt organizations, the proposed regulations include all the 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 Notice 2018-67) in the list of “investment activities” treated as a separate unrelated trade or business for purposes of section 512(a)(6).

The Treasury Department and the IRS note that rental of certain property is a trade or business that must be identified using NAICS 2-digit codes. For example, section 512(b)(3)(B) provides that rents from real and personal property are included in UBTI if more than 50 percent of the total rent received or accrued under a lease is attributable to personal property. Also, § 1.512(b)-1(c)(5) indicates that payments for the use or occupancy of rooms or other space where services are also rendered to the occupant do not constitute rent from real property. Sections 512(b)(4) and 514 do not apply where such real or personal property is purchased with debt financing because the rents from these properties will have already been included in UBTI.
See
section 514(b)(1)(B) (providing that, except in the case of income excluded under section 512(b)(5), the term “debt-financed property” does not include any property to the extent that the income from such property is taken into account in computing the gross income of any unrelated trade or business); § 1.514(b)-1(b)(2)(i). Accordingly, because rent from such real and personal property is included in UBTI, the exempt organization must identify such unrelated trade or business using the NAICS 2-digit code for real estate rental and leasing (53).

b. Specified Payments Received From Controlled Entities

Notwithstanding section 512(b)(1), (2), and (3), section 512(b)(13)(A) requires an exempt organization, referred to as a “controlling organization,” that receives or accrues (directly or indirectly) a specified payment from another entity which it controls, referred to as a “controlled entity,” to include such payment as an item of gross income derived from an unrelated trade or business to the extent such payment reduces the net unrelated income of the controlled entity (or increases any net unrelated loss of the controlled entity).
See
§ 1.512(b)-1(l)(1). Section 512(b)(13)(C) defines the term “specified payment” as any interest, annuity, royalty, or rent. Accordingly, section 512(b)(13) treats certain amounts that would ordinarily be excluded from the calculation of UBTI under section 512(b)(1), (2), and (3) as income derived from an unrelated trade or business.

Commenters argued that amounts included in UBTI under section 512(b)(13) should be included with an exempt organization's other investment activities. Presumably, this argument rests on the premise that the types of payments described in section 512(b)(13)(C)—that is, any interest, annuity, royalty, or rent—might be characterized generally as “investment income.” However, treating specified payments included in UBTI as income from an exempt organization's investment activities would be inconsistent with the purpose of section 512(b)(13)(A), which is to prevent a controlled entity from gaining a competitive advantage (in contravention of the purposes of section 512) through making deductible payments to a controlling organization that is exempt from tax.
See
S. Rep. No. 91-552, at 73 (1969) (explaining that certain “rental” arrangements between exempt organizations and taxable subsidiaries

“enable[ ] the taxable [subsidiary] to escape nearly all of its income taxes”). Consistent with that purpose, section 512(b)(13)(A) treats a specified payment as income from an unrelated trade or business only “to the extent such payment reduces the net unrelated income of the controlled entity (or increases any net unrelated loss of the controlled entity).” Section 512(b)(13) thus views such payments as stemming from the trade or business activity of the controlled entity rather than from the “investment activity” of the controlling organization.

Further, the required degree of control of the controlling organization over the controlled entity indicates that the controlled entities are not a part of the controlling organization's otherwise appropriately characterized investment activities. In general, section 512(b)(13)(D) defines the term “control” as ownership of more than 50 percent of the stock in a corporation, of the profits interests or capital interests in a partnership, or, in any other case, of the beneficial interests in an entity. The section 318 constructive ownership rules apply when determining the ownership of stock in a corporation, and similar principles apply in determining the ownership of interests in other types of entities. As generally discussed in section 2.d.iii.B of this preamble, control over an organization suggests that such interest is not part of the exempt organization's investment activities. Accordingly, even though the controlled entity's trades or businesses might not be attributed to the controlling organization (such as in the case of a controlled corporation), the control itself indicates that the controlled entity is held as part of a trade or business other than the controlling organization's investment activities.

The plain language of section 512(b)(13) could require each specified payment to be treated as a separate unrelated trade or business under section 512(a)(6) because section 512(b)(13) requires an exempt organization to include such payment as an item of gross income derived from “an” unrelated trade or business. However, this treatment may impose a considerable administrative burden on controlling organizations that receive numerous specified payments from controlled entities, such as may be the case with a university or hospital system. Therefore, these proposed regulations permit an exempt organization to aggregate all the specified payments received from a controlled entity and to treat the payments as received from a single separate unrelated trade or business for purposes of section 512(a)(6).

In particular, the proposed regulations provide that, if an exempt organization controls another entity (within the meaning of section 512(b)(13)(D)), the specified payments from that controlled entity will be treated as gross income from a separate unrelated trade or business for purposes of section 512(a)(6). If a controlling organization receives specified payments from two different controlled entities, the payments from each controlled entity are treated as separate unrelated trades or businesses. For example, a controlling organization that receives rental payments from two controlled entities will have two separate unrelated trades or businesses, one for each controlled entity. The specified payments from a controlled entity will be treated as gross income from one unrelated trade or business regardless of whether the controlled entity engages in more than one unrelated trade or business or whether the controlling organization receives more than one type of specified payment from that controlled entity.

c. Certain Amounts Derived From Foreign Corporations

Section 512(b)(17) requires any amount included in gross income under section 951(a)(1)(A) to be included as an item of gross income derived from an unrelated trade or business to the extent the amount so included is attributable to insurance income (as defined in section 953) which, if derived directly by the exempt organization, would be treated as an unrelated trade or business. Section 953(a)(1) defines “insurance income” as any income that (A) is attributable to the issuing (or reinsuring) of an insurance or annuity contract, and (B) would (subject to certain modifications not relevant here) be taxed under subchapter L of chapter 1 if such income were the income of a domestic insurance company. Thus, section 512(b)(17) “applies a look-through rule in characterizing certain subpart F insurance income for unrelated business income tax purposes.” H.R. Rep. No. 104-586 (1996), at 137.

Commenters have argued that insurance income included in UBTI under section 512(b)(17) belongs in the category of investment activities. However, like section 512(b)(13), the required degree of control of the exempt organization over the controlled foreign corporation indicates that the exempt organization's interest in a controlled foreign corporation probably is not a part of the exempt organization's otherwise appropriately characterized investment activities. In particular, section 951(a)(1)(A) applies only if a foreign corporation is a controlled foreign corporation, which section 957 defines as any foreign corporation if more than 50 percent of the total combined voting power of all classes of stock of such corporation entitled to vote or the total value of the stock of such corporation is owned, directly, indirectly, or constructively by United States shareholders. Section 951(b) defines “United States shareholder,” with respect to any foreign corporation, as a United States person (within the meaning of section 7701(a)(30), which includes domestic corporations and certain trusts) who owns, directly, indirectly, or constructively, 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation.

Furthermore, insurance income included in UBTI under section 512(b)(17) should not be treated as gross income from an exempt organization's investment activities because the provision of insurance generally is an unrelated trade or business. Section 501(m) provides that, in the case of an exempt organization described in section 501(c)(3) or (4) that does not provide commercial-type insurance as a substantial part of its activities, the activity of providing commercial-type insurance is treated as an unrelated trade or business (as defined in section 513). However, rather than treating insurance income from each controlled foreign corporation as income from a separate unrelated trade or business, these proposed regulations treat the provision of insurance by all controlled foreign corporations as one trade or business, regardless of whether such insurance income is received from more than one controlled foreign corporation. This approach is consistent with how NAICS would categorize the provision of insurance (52—Finance and Insurance).

However, the proposed regulations do not permit the aggregation of an exempt organization's insurance income included in UBTI under section 512(b)(17) with any insubstantial commercial-type insurance activities conducted directly by the exempt organization because the controlled foreign corporation, not the exempt organization, is engaged in the activity giving rise to the insurance income included in UBTI under section 512(b)(17). The insurance activity is not attributed to the exempt organization

and thus is distinguishable from any commercial-type insurance activity engaged in directly by the exempt organization.

4. S Corporation Interest Treated as an Interest in an Unrelated Trade or Business

An S corporation is a “small corporation” that may elect to be treated under a simplified tax regime that acts as a hybrid between the rules for corporations and the rules for pass-through entities. In general, the items of income and loss of an S corporation are taxed directly to the shareholders of that corporation.
See
section 1366(a). The types of exempt organizations that are permitted to be shareholders of an S corporation are described in section 1361(c)(2)(A)(vi) and (6). Exempt organizations permitted to be S corporation shareholders include qualified retirement plans, exempt organizations described in section 501(c)(3), and certain IRAs (including, subject to the limitation described more specifically in 1361(c)(2)(A)(vi), an IRA designated as a Roth IRA under section 408A).

For purposes of the unrelated business income tax, section 512(e) provides special rules applicable to S corporations. Section 512(e)(1)(A) provides that, if an exempt organization permitted to be an S corporation shareholder holds stock in an S corporation, such interest will be treated as an interest in an unrelated trade or business. Thus, notwithstanding any other provision in sections 511 through 514, section 512(e)(1)(B) requires an exempt organization permitted to hold S corporation stock to take the following amounts into account in computing the UBTI of such exempt organization: (i) All items of income, loss, or deduction taken into account under section 1366(a) (regarding the determination of an S corporation shareholder's tax liability); and (ii) any gain or loss on the disposition of the stock in the S corporation.

Notice 2018-67 did not address, or request comments on, the treatment of amounts taken into account in computing UBTI under section 512(e). Nonetheless, one commenter recommended that UBTI from an S corporation should be treated as income from a single trade or business regardless of the manner in which such income is earned by the S corporation. The commenter stated that having to separate all the income producing activities of an S corporation would be extremely burdensome. Accordingly, the commenter recommended that all income from an S corporation should be aggregated with the income from QPIs to ensure similar treatment of all pass-through entities. In the alternative, the commenter suggested combining all income from S corporations in which the exempt organization shareholder owns less than 50 percent of the shares with the income from QPIs.

The proposed regulations generally provide that each S corporation interest will be treated as an interest in a separate unrelated trade or business, which is consistent with the language of section 512(e)(1)(A). Accordingly, if an exempt organization has two S corporation interests (that are not qualifying S corporation interests described in section 4.a of this preamble), the exempt organization will report two trades or businesses, one for each S corporation interest. The treatment of each S corporation interest as one trade or business for purposes of section 512(a)(6) is similar to the treatment of specified payments from a controlled entity under section 512(b)(13). Furthermore, the Treasury Department and the IRS view this treatment as best serving the purposes of section 512(a)(6).

Section 512(e) provides two different rules: One for items of income, loss, or deduction taken into account under section 1366(a) and one for any gain or loss on the disposition of S corporation stock. Although these amounts could be treated as separate unrelated trades or businesses for purposes of section 512(a)(6) due to the disparate methods of inclusion in the language of section 512(e), such treatment would artificially divide each S corporation interest into two trades or businesses. The separate enumeration of the gain or loss on the disposition of S corporation stock serves to override section 512(b)(5), which would otherwise exclude such gain or loss from the calculation of UBTI, and not to indicate the existence of a separate unrelated trade or business. Accordingly, the proposed regulations provide that the UBTI from an S corporation interest is the amount described in section 512(e)(1)(B), which includes both the items of income, loss, or deduction taken into account under section 1366(a) and the gain and loss on the disposition of S corporation stock.

a. Qualifying S Corporation Interests

Notwithstanding the general rule that each S corporation interest is treated as a separate unrelated trade or business, the Treasury Department and the IRS recognize that an exempt organization may hold S corporation stock for different purposes, including investment purposes. Additionally, the look-through treatment of an S corporation is similar to the look-through treatment of a partnership. As discussed in section 2.d of this preamble, these proposed regulations permit the aggregation of QPIs to mitigate the burden on exempt organizations with interests in multi-tier partnerships. Similarly, the proposed regulations permit an exempt organization to aggregate its UBTI from an S corporation interest with its UBTI from other investment activities if the exempt organization's stock ownership (by percentage of stock ownership) in the S corporation meets the requirements provided in the de minimis test or the control test for “qualifying partnership interests.” As such, if an exempt organization owns (by percentage of stock ownership) 2 percent or less of the stock in an S Corporation, or, if it owns 20 percent or less of the stock in such S corporation and meets the facts and circumstances requirements under the second prong of the control test, then such S corporation interest will be a “qualifying S corporation interest” and can be aggregated with other investment activities. When determining an exempt organization's percentage ownership of stock in an S corporation, the exempt organization must apply the same rules for combining related interests that are used to determine whether a partnership interest is a QPI. An exempt organization may rely on the Schedule K-1 (Form 1120-S) that the exempt organization receives from the S corporation when determining its percentage ownership of the stock in such S corporation.

b. Employee Stock Ownership Plans

Section 512(e)(3) provides that section 512(e) does not apply to employer securities (within the meaning of section 409(l)) held by an employee stock ownership plan (ESOP) described in section 4975(e)(7). ESOPs holding S corporation stock (“S corporation ESOPs”) are subject to the limits imposed by section 409(p) on the concentration of S corporation ownership. Ownership includes shares allocated to the accounts of ESOP participants. Failing to meet the requirements of section 409(p) will result in the imposition of an excise tax on the S corporation and other adverse consequences to the ESOP and certain individuals. Although section 512(e) generally does not apply to S corporation ESOPs, the application of section 409(p) to an S corporation ESOP might give rise to UBTI. The primary means of avoiding a section 409(p) failure is for the S corporation ESOP to transfer some of its S corporation shares

to a non-ESOP portion of the plan or to another qualified retirement plan of the employer.
See
§ 1.409(p)-1(b)(2)(v)(A)-(B). Such a transfer may result in a significant number of S corporation shares being held by the non-ESOP portion of an S corporation ESOP or by another section 401(a) plan (“transferee plan”). The transferred shares, no longer held in an ESOP, are not described in section 512(e)(3). Accordingly, the transferee plan treats the S corporation interest resulting from the transfer of the S corporation shares as an interest in an unrelated trade or business under the general rule of section 512(e)(1) and takes the amounts described in section 512(e)(1)(B) into account in computing UBTI. The Treasury Department and IRS anticipate that a transferee plan is not likely to have more than one S corporation interest. However, whether such S corporation interest may be aggregated with the investment activities of the transferee plan will depend on whether the S corporation interest is a qualifying S corporation interest. The Treasury Department and the IRS request comments on this issue.

5. Social Clubs, Voluntary Employees' Beneficiary Associations, and Supplemental Unemployment Benefits Trusts

As noted in the Background section, section 512(a)(3) provides a special definition of UBTI for social clubs, VEBAs, and SUBs. Section 512(a)(3)(A) defines UBTI, in part, as “gross income (excluding exempt function income).” “Gross income” under section 61(a) includes “gains derived from dealings in property,” “interest,” “rents,” “royalties,” “dividends,” and “annuities.”
See
section 61(a)(3) through (8). Consistent with section 61(a), the gross income subject to the unrelated business income tax under section 512(a)(3) generally includes interest, annuities, dividends, royalties, rents, and capital gains because the modifications in section 512(b)(1), (2), (3), and (5) that exclude such amounts from UBTI for organizations subject to section 512(a)(1) are not available under section 512(a)(3). Accordingly, social clubs, VEBAs, and SUBs generally must include interest, dividends, royalties, rents, and capital gains in UBTI unless such amounts may be set aside for a purpose described in section 512(a)(3)(B)(i) or (ii) and therefore would be exempt function income excluded from UBTI under section 512(a)(3)(A).

Section 512(a)(3)(B) defines “exempt function income” as (1) “the gross income from dues, fees, charges, or similar amounts paid by members of the organization as consideration for providing such members or their dependents or guests goods, facilities, or services in furtherance of the purposes constituting the basis for the exemption of the organization;” and (2) “all income (other than an amount equal to the gross income derived from any unrelated trade or business regularly carried on by such organization computed as if the organization were subject to [section 512(a)(1)]) which is set aside” for one of the purposes described in section 512(a)(3)(B)(i) or (ii). Such amounts set aside include reasonable costs of administration directly connected with a purpose described in section 512(a)(3)(B)(i) or (ii).

Section 512(a)(3)(B)(i) includes in exempt function income amounts set aside for a purpose specified in section 170(c)(4), that is, exclusively for religious, charitable, scientific, literary, or educational purposes. In the case of a VEBA or SUB, section 512(a)(3)(B)(ii) includes in exempt function income amounts set aside to provide for the payment of life, sick, accident, or other benefits. Section 512(a)(3)(E) limits the amounts that may be set aside under section 512(a)(3)(B)(ii). In general, section 512(a)(3)(E)(i) provides that a set aside for any purpose described in section 512(a)(3)(B)(ii) may be taken into account as exempt function income only to the extent that such set aside does not result in an amount of assets set aside for such purpose in excess of the account limit determined under section 419A (without regard to section 419A(f)(6)) for the taxable year (not taking into account any reserve described in section 419A(c)(2)(A) for post-retirement medical benefits).

In determining what income may be set aside under 512(a)(3)(B)(i) or (ii), the income available is “all income (other than an amount equal to the gross income derived from any unrelated trade or business regularly carried on by such organization computed as if the organization were subject to [section 512(a)(1)]).” This parenthetical language, by referencing “the gross income from any unrelated trade or business computed as if the organization was subject to [section 512(a)(1)],” pulls in the modifications of section 512(b) applicable to that computation. Accordingly, amounts excluded from UBTI under section 512(a) via the modifications in section 512(b) (such as interest, dividends royalties, rents, and capital gains) are available to be set aside for the purposes of section 512(a)(3)(B)(i) and (ii) and may constitute exempt function income, subject to the other applicable limitations.

For example, if a social club has interest and dividends, and does not set aside any amount of such interest or dividends for a purpose specified in section 170(c)(4), then the full amount of the interest and dividends would constitute UBTI under section 512(a)(3). However, if the social club sets aside any amount of the interest or dividends for a purpose specified in section 170(c)(4), the amount of the interest and dividends set aside would be excluded from the calculation of UBTI under section 512(a)(3)(B)(i) as exempt function income (provided that such amount set aside actually is used for a purpose specified in section 170(c)(4)). Similarly, a VEBA with interest and dividends may set aside amounts to provide for the payment of life, sick, accident, or other benefits, subject to the limitations of section 512(a)(3)(E).
4

Such amount set aside will be excluded from UBTI as exempt function income (provided that such amount actually is used to provide for the payment of benefits).

4

See
Treas. Reg. § 1.512(a)-5(c).

Notice 2018-67 anticipated that the rules issued regarding how an exempt organization identifies separate trades or businesses for purposes of section 512(a)(6)(A) generally would apply under both section 512(a)(1) and (3). Nonetheless, because social clubs, VEBAs, and SUBs are taxed differently than other exempt organizations under section 511, Notice 2018-67 requested comments regarding any additional considerations that should be given to how section 512(a)(6) applies within the context of section 512(a)(3), and, in particular, how the income from investment activities of these organizations should be treated for purposes of section 512(a)(6).

Commenters generally agreed that social clubs should be subject to the same rules as exempt organizations subject to section 512(a)(1) when determining whether the social club is subject to section 512(a)(6). A social club therefore would identify its unrelated trades or businesses using NAICS codes and treat the income derived from investment activities as a separate unrelated trade or business. Only one commenter addressed how section 512(a)(6) should apply to VEBAs. This commenter suggested that VEBAs would not be subject to section 512(a)(6) because the unrelated trade or business activities of the VEBA could be identified under one NAICS 6-digit code—the code for health and welfare funds (525120). However, as explained in section 1.a.i of this preamble, an exempt organization cannot use a

NAICS 2-digit code describing the activities the conduct of which is substantially related to the exercise or performance by such exempt organization of the purpose or function constituting the basis for its exemption under section 501. No commenter addressed how section 512(a)(6) should apply to a SUB.

Consistent with the statement made in Notice 2018-67, the Treasury Department and the IRS have determined that a social club, VEBA, or SUB will determine whether it has more than one unrelated trade or business in the same manner as an exempt organization subject to section 512(a)(1) except as discussed in sections 5.a and b of this preamble.

a. Investment Activities

As discussed in section 2 of this preamble, the proposed regulations treat certain “investment activities” (that is, QPIs, qualifying S corporation interests, and debt-financed property or properties) as a separate unrelated trade or business for purposes of section 512(a)(6) and the proposed regulations. Thus, a social club, VEBA, or SUB generally will treat the investment activities specifically listed in the proposed regulations as a separate unrelated trade or business

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-06604. Public record. Not legal advice.