The IRS issued proposed regulations on the new rule that requires tax-exempt organizations subject to tax on unrelated business taxable income (UBTI) to calculate UBTI separately with respect to each business — or to "silo" revenue and expenses for each separate business. The silo rules are found in Sec. 512(a)(6), which was enacted in the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97.
Under prior law, UBTI was the gross income of all unrelated trades or businesses less the allowed deductions from all unrelated trades or businesses. Effective for tax years beginning after Dec. 31, 2017, in the case of an organization with more than one unrelated trade or business, UBTI is calculated separately for each trade or business and may not be less than zero.
The IRS had issued interim guidance in Notice 2018-67, which permitted taxpayers to identify separate trades or businesses by using the six-digit codes of the North American Industry Classification System (NAICS). In the proposed regulations, however, the IRS, in response to comments, proposed to use the two-digit NAICS codes that designate the sector of economic activity, such as "retail trade" or "accommodation and food services." By using those broader classifications, the IRS is making it easier for exempt organizations to determine which code applies. The AICPA recommended in November 2019 that the IRS and Treasury should allow taxpayers to use shorter, more general NAICS codes to separate and classify unrelated trades or businesses (see the comment letter).
Once it breaks the businesses into separate silos, the organization must determine how to allocate to each silo expenses that may apply to more than one activity. Until the IRS issues further guidance on the issue, the expenses may be allocated using any reasonable method.
The AICPA recommended in its comment letter that a tax-exempt organization, in choosing a method for expense allocation, should use the general standard of "reasonable and necessary" and consistently follow the same method from year to year and that the selected method should not result in the double-counting of any expenses. The IRS and Treasury are continuing to consider the allocation issue and intend to publish separate proposed regulations providing further guidance on this issue.
Consistent with Notice 2018-67, the proposed regulations provide that an exempt organization's various investment activities are generally treated as one separate unrelated trade or business. The AICPA also had made previous recommendations supporting the intention that an exempt organization's investment activities should be treated as a single trade or business.
The proposed regulations specifically list investment activities that can be treated as one separate unrelated trade or business: (1) qualifying partnership interests; (2) debt-financed properties; and (3) qualifying S corporation interests.
The proposed regulations also address how individual retirement accounts are treated under these rules, explaining that they are treated as trusts and are subject to the unrelated trade or business rules. 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 Sec. 512 and are therefore excluded from UBTI.
In addition, the proposed regulations address net operating losses (NOLs). They clarify that the language of Sec. 512(a)(6) and Section 13702(b) of the TCJA do not alter the ordering rules under Sec. 172. Therefore, the proposed regulations provide that an exempt organization with both pre-2018 and post-2017 NOLs will deduct its pre-2018 NOLs from its total UBTI under Sec. 512(a)(6)(B) before deducting any post-2017 NOLs with regard to a separate unrelated trade or business from the UBTI from that unrelated trade or business. The proposed regulations clarify that pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a tax year. In its previous comments the AICPA had asked for additional guidance on NOLs and the ordering rules. Treasury and the IRS will further consider, and may issue additional guidance on, how changes to Sec. 172 made by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, including temporary repeal of NOLs' limitation of 80% of taxable income and temporary allowance of a five-year carryback of NOLs, affect UBTI calculations under Sec. 512(a)(6).
Final regulations will apply to tax years beginning on or after the date they are published as final. For tax years beginning before that date, an exempt organization may rely on a reasonable, good-faith interpretation of Secs. 511—514, considering all the facts and circumstances, when identifying separate unrelated trades or businesses for purposes of Sec. 512(a)(6)(A). In addition, for these same tax years, an exempt organization may rely on these proposed regulations in their entirety. Alternatively, for these same tax years, an exempt organization may rely on the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67.
The AICPA plans to submit an additional comment letter on the proposed regulations that will further discuss recommendations related to areas that the government has requested additional feedback on, such as the NAICS two-digit code classification, investment activities, the de minimis and control tests, NOLs, the transition rule, and social club issues.
— By Sally P. Schreiber, J.D., a JofA senior editor.