Guidance for Applying ‘Silo’ Rules to Unrelated Business Taxable IncomeBy Magdalena M. Czerniawski | Robert Lyons | April 28, 2020
As part of the Tax Cuts and Jobs Act (TCJA) enacted in December 2017, two significant code sections were added that had a major impact on tax-exempt organizations. Section 512(a)(7), regarding the taxation of transportation fringe benefits, was repealed on December 20, 2019. Section 512(a)(6), concerning the “siloing” of separate lines of business for unrelated business income tax purposes, remains in effect. On April 23, 2020, Treasury issued IR-2020-78, a 115-page notice on the implementation of Section 512(a)(6). Of the 115 pages, 18 consist of regulations and the other 97 pages explain the implementation of the ”silo” rules. Initial guidance was provided in Notice 2018-67. The proposed regulations implement certain recommendations found in Notice 2018-67 and clarify that the definition of “unrelated trade or business” also applies to activities carried out by Individual Retirement Accounts.
Section 511(a)(1) imposes a tax on an organization’s unrelated business taxable income (UBTI). Simply put, UBTI is income that is not substantially related to the exercise or performance by such exempt organizations of their charitable, educational or other purpose or function constituting the basis for tax exemption and is regularly carried on. For a majority of organizations, this represents the income reported on a K-1 issued by an investment partnership. For others it might come from the rental of debt-financed real estate. This income can be either direct or indirect as might be the case in an investment partnership.
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 trade or business. As such, a deduction (loss) from one trade or business for a taxable year cannot be used to offset income from a different unrelated activity for the same taxable year. Simply put, an organization with more than one unrelated activity cannot use the loss from an activity to offset the income from another activity. Prior to the TCJA, all unrelated activities of an organization were aggregated to generate a net income or loss, as the case may be. The primary focus of the proposed regulations is to establish a method for determining whether an exempt organization has more than one unrelated trade or business for the purpose of siloing.
What Constitutes a ‘Trade or Business’?
There is no general statutory or regulatory definition of what activities constitute a “trade or business.” Whether an activity constitutes a trade or business depends on both the nature of the business and the relationship to an organization’s exempt purpose. What might be related to one organization could be unrelated to another. For example, an organization created to provide rental of apartments to low-income families is an acceptable exempt purpose, whether or not the building is debt financed. However, renting of debt-financed property could be UBTI if operated on an unrelated basis with a profit motive in mind. For purposes of the regulations, the term “trade or business” is used in the same way as any activity whose primary purpose is the production of income from the sale of goods or services.
Notice 2018-67 allowed for a “reasonable, good-faith interpretation” based on the facts and circumstances when determining separate lines for the purpose of siloing. Notice 2018-67 noted that the IRS was considering the use of the North American Industry Classification System (NAICS) codes to determine whether an exempt organization has more than one line of business for purposes of Section 512(a)(6). The structure of NAICS is hierarchical, using a six-digit coding system, and divides the economy into 20 sectors. The first two digits of the code designate the sector such as retail trade (44-45), real estate or rental and leasing (53). The third digit designates the subsector, the fourth designates the industry group and the fifth designates the NAICS industry. The sixth digit designates the industry with increased specificity. Getting this granular would be extremely burdensome for an organization to track. As a result, the proposed regulations provide that an exempt organization generally will identify its separate activities by using the first two digits of the NAICS code (i.e., sector). This significantly reduces the burden on investment activities held by most applicable tax-exempt organizations.
Before an organization can contemplate the use of the codes, it must first determine if the activity is a trade or business. If determined to be an unrelated trade or business, then the organization can use the two-digit code to determine the category. In determining businesses of like-kind for grouping purposes, there has to be a profit motive in order to be included in the group. This would preclude an organization from entering into a business activity for the purpose of producing a loss to reduce the income in a category. In the discussion in Notice 2020-78, the IRS cited a relatively old but significant case involving profit motive. (See Portland Golf Club v. Commissioner, 497 U.S. 154, 164 (1990)). All activities within a group have to be carried out with a profit motive. As a result of the proposed regulations, the IRS is planning to modify Form 990-T and the related instructions to include the two-digit coding system. Once an organization has included an activity within a group, it cannot change the category in a future year unless there was a mistake or a material change in circumstances.
Once an organization determines that it does have UBTI and establishes a two-digit code for the activity, it then has to turn to the allocation of expenses associated with the activity. There is generally little question in the case of direct expenses. The problem arises when indirect expenses are introduced. For example, a food and beverage operation will have food costs that may be direct, but how will it allocate shared administrative costs? Section 512 states that expenses are allocated based on whether they are “ordinary, necessary and reasonable” depending on all the facts and circumstances. The IRS believes this is too arbitrary and not necessarily reflective of reality and takes the position that the only definition of “reasonable” is “actual.” Notice 2020-78 goes into detail that the “gross to gross” method cannot be used under any circumstances (e.g., allocating salaries in relationship to the gross income produced by the activity). The Notice states that Treasury and the IRS will continue to consider the allocation issue and will publish a separate notice of proposed rulemaking specifically to cover the issue of cost allocation.
In remaining consistent with Notice 2018-67, the proposed regulations generally permit the aggregation of investment activities specifically listed in the proposed regulations for purposes of Section 512(a)(6). However, under the proposed regulations, investment activities are not identified using the NAICS two-digit codes because they are not specifically a trade or business except as otherwise defined in the proposed regulations. For purposes of Section 512(a)(6), investment activities are treated as a separate activity or line of business. A significant portion of Notice 2020-78 details what and how activities are included in this group. Debt-financed activities are discussed separately from “traditional” investments made by an exempt organization. The discussion relies on Notice 2018-67, which states that, as a matter of administrative convenience, the proposed regulations would treat an exempt organization’s investment activities as one trade or business in order to permit the exempt organization to aggregate gross income and directly connected deductions from possibly multiple separate unrelated trades or businesses.
The proposed regulations limit, with some modifications, investment activities to:
- qualifying partnership interest;
- qualifying S corporation interest; and
- debt-financed property within the meaning of Section 514.
A qualified partnership interest can be directly or indirectly held. A directly held partnership interest is treated as a qualifying partnership interest (QPI) if the exempt organization holds a direct interest in a partnership that meets the requirements of either the de minimis test or the control test. Indirectly held partnership interest classifications are measured through a very complex set of rules. To meet the requirements of an investment partnership interest for purposes of Section 512a)(6), the organization should only include interest in which the exempt organization does not significantly participate in any trade or business.
The de minimis and control tests are discussed but only insofar as they relate to Notice 2018-67, providing that an organization can hold no more than a two percent direct interest of the profits and no more than a two percent interest in the capital of an investment. 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 itself. The proposed regulations retain the 20 percent threshold used in Notice 2018-67.
Many investments held by an organization are not taxable due to certain modifications provided for in Section 512 (interest, dividends, rents, royalties, etc.) unless they are debt financed as defined in Section 514. In the case of debt-financed property, organizations are required to include the income as if it was from an unrelated trade or business. Notice 2018-67 attempted to make an argument for requiring each debt-financed property to be treated as a separate unrelated trade or business. The proposed regulations clarify that debt-financed activities generally are held for investment purposes. To reduce the burden on exempt organizations, the proposed regulations include all the UBTI from an exempt organization’s debt-financed property in the list of investment activities. They do, however, note that some activities, such as rental activities where there is both personal and real property involved, should be identified more appropriately with the NAICS-2 codes.
Another area that can be problematic is payments received from a controlled entity. In general, if one taxable organization can take a deduction for what would otherwise not be taxable to an exempt organization, such as interest, dividends royalties and rents, and they meet the 50 percent control test, then under Section 512(b)(13) the otherwise exempt income would be taxable. In this case, the proposed regulations provide that if an exempt organization controls another entity, 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). Furthermore, if a controlling organization receives specified payments from two different controlled entities, the payments from each controlled entity are treated separately.
Notice 2020-78 amplifies but does not modify the treatment of net operating losses other than to discuss the changes to Section 172 limiting the amount of net operating losses that could be applied in any given year. Notice 2018-67 separated the pre-2018 net operating losses from those post-enactment. Post-enactment carryovers are separately pooled for each trade, business or investment group. Pre-enactment losses cannot be applied until post losses are used. If a post-enactment investment continued to produce losses, aside from the profit motive issue, it is conceivable that pre-enactment losses could run beyond the 20-year carryover.
Notice 2020-78 covers a number of other areas that are addressed in the proposed regulations. While these areas do not typically affect tax-exempt organizations, they should be aware of their presence. These other areas include:
- employee stock ownership plans;
- social clubs;
- voluntary employees’ beneficiary associations;
- supplemental unemployment benefit trusts; and
- individual retirement accounts.
The proposed regulations apply to taxable years beginning on or after the date published in the Federal Register as final regulations. Until then, organizations can continue to make reasonable, good-faith interpretations of Sections 511 through 514. To the extent an organization relies on the proposed regulations, they will constitute substantial authority in their entirety.
The above is just a summary of the proposed regulations. For further information, please contact your Marks Paneth advisor.
About Magdalena M. Czerniawski
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 (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 +