Nonprofit Alert: New IRS Guidance on UBTI Silos

By Magdalena M. Czerniawski |  Robert Lyons  |  September 4, 2018


On August 21, 2018, the Internal Revenue Service issued Notice 2018-67 (“Notice”) with guidance and request for comments on Section 13702 of the Tax Cut and Jobs Act of 2017).  The Notice concerns the new Code section 512(a)(6), which requires an organization subject to unrelated business income tax with more than one line of business to calculate its unrelated business taxable income (“UBTI”) separately with respect to each line.

This new separation between different lines of business is effective for organizations with years beginning after December 31, 2017.  The Notice offers limited guidance on the “separate lines of business” accounting necessary to implement Code section 512(a)(6).  However, it does outline general concepts for recognizing separate lines of business and addresses specific circumstances identifiable with some of the more common lines of activities such as partnerships and debt-financed income.


Organizations described in Code section 401(a) and 501(c) are generally treated as exempt from income tax as long as their activities align with their specific exempt purpose.  However, Code section 511(a)(1) imposes a tax on activities that are unrelated to the organization’s exempt purpose and are regularly carried on, with the exception of certain passive investments, such as income from interest, dividends royalties, etc., unless they are “debt-financed.”

Code section 513(a) defines “unrelated trade or business” as any regularly carried-on trade or business, the conduct of which is not substantially related to the exercise or performance of the organization’s specific exempt function. 

However, exempt organizations can exclude the following from the calculation of UBTI interest: dividends, annuities, royalties, rents and gains and losses from the sale, exchange or disposition of property.  This assumes that the activity is passive in nature and not debt-financed. These sources of income have historically been treated as “proper” sources of income for exempt organizations.

The New Law

The problem that often arises for many exempt organizations is when this activity is not carried on directly by the organization but rather through a vehicle such as a partnership.  Code section 512(c) provides that, if a trade or business is regularly carried on by a partnership where an exempt organization is a partner, then the exempt organization includes its share of UBTI, subject to exceptions and limitations, in its taxable income.  The problem arises in determining if the partnership is carrying one or more line of business within the partnership itself, or whether separate partnerships are carrying on separate lines of business.   These rules apply whether the exempt organization is a general or limited partner.

Until the introduction of Code section 512(a)(6) an organization could conduct multiple lines of unrelated activities and aggregate gross income and expenses from all such activities together, thereby offsetting profitable activities with the less profitable ones and not paying unrelated business income tax.  However, Code section 512(a)(6) substantially changes this rule.  The intent is that the loss from one line of business cannot be used to offset the income from another. In addition, UBTI used in determining a net operating loss (NOL) deduction has to be computed separately for each trade or business line without regard to the specific deduction of $1,000.  More simply put, under the new Code section 512(b)(6), UBTI with respect to any such trade or business cannot be below zero.

Separate Trade or Business

Much of the controversy evolves around “separate unrelated trades or businesses.  Unfortunately, neither Congress nor the IRS have been forthcoming with a definition.  The Treasury Department and the IRS intend to propose regulations at some point in the future to define separate lines of business.  Until such time, this Notice calls for using a “reasonable, good-faith interpretation based on the facts and circumstances.” 

One suggestion is to define the lines of business using North American Industry Classification System 6-digit codes (NAICS codes).  Treasury and IRS have also suggested using the “fragmentation principle” as guidance.  The fragmentation principle provides that an activity does not lose its identity as a trade or business merely based on the scale of the activity.  Neither of these methods provide much needed guidance.

Several Code sections describe factors for determining whether an organization is engaged in a line of business.  But according to the IRS these factors would lead to increased administrative burden and lack of consistency, which would make the entire process difficult to administer.  This would lead to a “fact-intensive analysis” which most organizations don’t have the resources or knowledge to perform.   

Along with the problems associated with defining what constitutes a separate trade or business is the difficulty in the allocation of “directly connected expenses”.  The Code permits an exempt organization with unrelated business income (“UBI”) to reduce gross income by directly related expenses incurred in connection with carrying on such trade or business.  This becomes another matter of judgment allowing for a series of inconsistent interpretations.  Again, Treasury and the IRS are looking into proper methods of allocation which will be forthcoming in the future.  At this point, they are asking taxpayers to use “any reasonable method.”

Investment Activities

Partnership interests – At this point, it remains unclear whether an exempt organization that is a partner in a partnership which invests in lower-tier partnerships engages in one or more unrelated trades or businesses.   One interpretation of 512(a)(6) is that the exempt organization may be engaged in multiple separate unrelated trades or businesses through its interest in the partnership.  In this regard, because of the administrative burden, the Treasury and IRS intend to propose regulations treating certain activities in the nature of an investment as one trade or business for this purpose.  This permits an organization to aggregate gross income and directly connected expenses from such “investment activities.” Until further guidance is issued, Treasury and IRS are suggesting a reasonable, good-faith interpretation and considering all the facts and circumstances when identifying separate trades or businesses for this purpose.

De Minimis and Control Test – The Notice suggests that until further guidance is issued, and exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses as long as the directly-held interest in the partnership meets the requirements of either the de minimis test or the control test.  In addition, an exempt organization can aggregate all qualifying partnership interests and treat the aggregate group of qualifying partnership interests as comprising a single trade or business. 

A partnership interest is a qualifying partnership interest if it 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, it is presumed to be meeting the de minimis test.  When determining an exempt organization’s percentage partnership interest, the interest of a disqualified person, a supporting organization, or a controlled entity in the same partnership are aggregated. After factoring the indirect interest, the organization that doesn’t meet the de minimis test, might still be able to aggregate the partnership interest if it meets the control test described below.

In regard to the control test, a partnership interest is a qualifying partnership interest that meets the requirements of the control test if the exempt organization directly holds no more than 20 percent of the capital interest and is not in a position of control of the partnership based on the facts and circumstances.  When determining the exempt organization’s percentage interest, the organization may rely on the Schedule K-1 it received from the partnership.   

In evaluating partnership activities, the income from qualifying partnership interests permitted to be aggregated under the interim rule includes any unrelated debt-financed income that arises in connection with the qualifying partnership interest that meets the requirements of either the de minimis test or the control test.

Revised Treatment of Net Operating Losses

The Notice substantially changes the way an organization can use its Net Operating Losses (“NOLs”).  Prior to the change in the law, an organization could aggregate its activities and apply its NOLs against the income without regard to the modifications described in Code section 512(b)(e.g. passive investments) and carry it back for two years or carry it over for a period of 20 years.

Code section 512(a)(6) changes how an exempt organization with more than one trade or business can use its NOLs.  For purposes of determining the NOL with respect to a trade or business, each activity has to be segregated.  Simply put, an activity producing income can only be offset with an NOL from the same activity for years beginning after December 31, 2017.  This produces an interesting result wherein, during the first taxable year beginning after December 31, 2017, no exempt organization with more than one line of business will have an NOL deduction to take against the UBTI of a particular trade or business.

For the first year (2018), an exempt organization can apply its pre-enactment losses carried over from prior years.  However, starting with the second year there is an ordering requirement for NOLs.  Section 512(a)(6) requires that post enactment losses have to be applied prior to pre-enactment carryovers.  Depending on the nature of the separate activities, this could cause pre-enactment losses to expire without ever being used.  The Act also limits the use of NOLs to the lesser of: (1) the aggregate NOL carryovers to such year, plus the NOL carrybacks to such year, or (2) 80 percent of the taxable income computed without regard to the deduction generally allowable under the prior NOL rules.  The limitation applies to post-2017 NOLs, but a question still exists regarding how the limitation applies when both pre-2018 and post-2017 NOLs exist.  Further guidance from Treasury and IRS is forthcoming on the proper treatment of the NOL pre/post mix.

Unlike Code section 512(a)(6), Code section 512(a)(7) [Disallowed Fringe Benefits], does not treat amounts included in UBTI as a result of that section as an item of gross income derived from an unrelated trade or business.  Treasury and IRS do not believe that the provision of the fringe benefits described in Code section 512(a)(7) is an unrelated trade or business; accordingly, any amount included in UBTI under Code section 512(a)(7) is not subject to Code section 512(a)(6) segregation rules. Therefore, the NOL limitations would not apply in the case of the treatment of fringes.


The new Code section 512(a)(6) requires an exempt organization to determine total UBTI and NOL with respect to each separate trade or business, less a specific deduction. 

Notice 2018-67 offers little in the way of practical guidance.  However, until Treasury and the IRS issue regulations the Notice calls for using a reasonable approach in determining separate lines of businesses. The de minimis and control rules will hopefully provide the most useful approach to aggregation of the various investment activities until further guidance is offered.

About Magdalena M. Czerniawski

Magdalena M. Czerniawski Linkedin Icon

Magdalena M. Czerniawski, CPA, MBA, is a Partner at Marks Paneth LLP and a member of the firm’s Nonprofit, Government & Healthcare Group. With over 15 years of nonprofit industry experience, she provides tax services to a wide array of nonprofits, including charitable organizations, schools, social welfare organizations, professional associations and private foundations. In addition to providing tax planning and advisory services, Ms. Czerniawski specializes in matters related to ASC 740-10 (FIN 48), the reporting... READ MORE +

About Robert Lyons

Robert Lyons Linkedin Icon

Robert (Rob) Lyons, CPA, MST, is a Tax Director, Exempt Organizations in the Nonprofit, Government & Healthcare Group at Marks Paneth LLP. Mr. Lyons brings to this role the skills he has developed during more than 30 years of providing tax and consulting services to his clients in the nonprofit, higher education, and public sector industries. His experience includes handling substantial exempt organization tax issues. Mr. Lyons has testified in front of the House and Ways Committee in... READ MORE +

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