Tax News & Views: Health Care Edition

Final Regulations on Unrelated Business Income Siloing

On November 19, 2020, the Treasury Department (“Treasury”) and the Internal Revenue Service (IRS) released final regulations (T.D. 9933, the “Final Regulations”) under IRC section 512(a)(6) regarding computing unrelated business taxable income (UBTI) separately for each trade or business of a tax-exempt organization. The Final Regulations are generally applicable to taxable years beginning on or after December 2, 2020, though special effective date rules may apply.

The Final Regulations largely adopt the proposed regulations released in April 2020 (REG-106864-18, the “Proposed Regulations”) with minor changes, as discussed below.

The Final Regulations adopt the Proposed Regulations with certain modifications. In addition, the preamble to the Final Regulations states that Treasury and the IRS anticipate publishing a separate notice of proposed rulemaking that addresses (i) allocation of expenses, depreciation, and similar items shared between an exempt activity and an unrelated trade or business or between more than one unrelated trade or business, and (ii) changes made to the IRC section 172 net operating loss (NOL) deduction by the CARES Act (P.L. 116-136).

Consistent with the Proposed Regulations, the Final Regulations provide that a tax-exempt organization must identify its separate unrelated trades or businesses using the North American Industry Classification System (NAICS) codes and provide specific rules for investment activities and certain controlled entities. As discussed below, the Final Regulations also provide guidance on the reasonable allocation of deductions, treatment of NOLs, public support test implications and other provisions.

Identifying separate unrelated trades or businesses using NAICS codes

Consistent with the Proposed Regulations, the Final Regulations provide that an exempt organization with more than one unrelated trade or business must compute UBTI separately with respect to each unrelated trade or business. The Final Regulations clarify that an organization determines whether it regularly carries on unrelated trades or businesses by applying IRC sections 511 and 514. The Final Regulations also adopt the rule in the Proposed Regulations that require an exempt organization to determine whether those activities are separate unrelated trades or businesses for purposes of IRC section 512(a)(6) based on the most accurate NAICS 2-digit codes describing the activities. The Final Regulations add that this determination is based on the first two digits of the more specific NAICS code, such as at the 6-digit level, that describes the activity the tax-exempt organization conducts.

In response to comments, the Final Regulations provide some flexibility and remove the restriction in the Proposed Regulations on changing certain erroneous NAICS 2-digit codes. Instead, the Final Regulations require an exempt organization that changes the identification of a separate unrelated trade or business to report the change in the taxable year of the change in accordance with forms and instructions to be provided on the Form 990-T, Exempt Organization Business Income Tax Return. A change in the identification of a separate unrelated trade or business includes the changed identification of the separate unrelated trade or business with respect to a partnership interest that was incorrectly designated as a qualifying partnership interest (QPI).

Allocation of directly connected deductions

Consistent with the Proposed Regulations, the Final Regulations provide that an exempt organization with more than one unrelated trade or business must allocate deductions between separate unrelated trades or businesses using the reasonable basis standard described in Treas. Reg. § 1.512(a)-1(c). In response to comments, the Final Regulations clarify that an allocation of expenses, depreciation, and similar items is not reasonable if the cost of providing a good or service in a related and unrelated activity is substantially the same, but the price charged for that good or service in an unrelated activity is greater than the price charged in the related activity and no adjustment is made to equalize the price difference for purposes of allocating expenses, depreciation, and similar items based on revenue between related and unrelated activities. This was referred to as the unadjusted gross-to-gross method in the Proposed Regulations.

Investment activities

The Final Regulations adopt the Proposed Regulations and allow aggregation of certain investment activities as one separate unrelated trade or business for purposes of IRC section 512(a)(6). The Final Regulations adopt the exclusive list of investment activities provided in the Proposed Regulations without change. Generally, these investment activities are limited to:

• QPIs,
• Qualifying S corporation interests (QSIs), and
• Debt-financed property or properties.

In addition, the Final Regulations adopt the proposed rules without change regarding the exclusion of specified payments from controlled entities and certain amounts from controlled foreign corporations (CFCs) from an exempt organization’s investment activities. Additionally, the Final Regulations adopt without change the Proposed Regulations’ treatment of debt-financed income (within the meaning of IRC section 514).

Rules for QPIs

The Proposed Regulations identified a partnership interest as a QPI if the exempt organization directly-held an interest that met the requirements of either the de minimis test or the control test. Special rules apply for indirectly held partnership interests. The Final Regulations do not adopt the recommended alternative methods for identifying a QPI suggested by commenters. However, the Final Regulations make several other modifications and clarifications:

General partner prohibition: The Final Regulations provide a per se prohibition against an exempt organization or its related party holding a general partner interest for purposes of being a QPI. A related party for this purpose is a supporting organization (other than a Type III supporting organization that is not a parent of the supported organization) or of a controlled entity. General partner status is determined under applicable state law. The preamble provides that Treasury and the IRS do not believe that this prohibition should be expanded to managing members’ interests in a limited liability company under applicable state law without the opportunity for further notice and comment.

De minimis test: A partnership interest is a QPI that meets the de minimis test if the exempt organization holds directly or indirectly no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership. The Final Regulations provide that the exempt organization must meet the percentage interest requirement of this rule during the exempt organization’s taxable year with which or in which the partnership’s taxable year ends.

Control test renamed the “participation test”: Under the Final Regulations, the control test described by the Proposed Regulations to determine if a partnership interest is a QPI is now called the participation test.

A partnership interest meets the participation test if the exempt organization directly or indirectly holds no more than 20% of the capital interest during the organization’s taxable year with which or in which the partnership’s taxable year ends and does not “significantly participate” in the partnership. The exempt organization must meet the 20% capital interest requirement for the exempt organization’s taxable year with which or in which the partnership’s taxable year ends.

“Significant participation” for purposes of the participation test is not determined using a general facts and circumstances test, as provided in the Proposed Regulations. Instead, the Final Regulations, with minor clarifications, retain an exclusive list of factors to demonstrate significant participation:

• The exempt organization, by itself, may require the partnership to perform, or prevent the partnership from performing (other than through a unanimous voting requirement or through minority consent rights), any act that significantly affects the operations of the partnership;
• Any of the exempt organization’s officers, directors, trustees, or employees have rights to participate in the management of the partnership at any time;
• Any of the organization’s officers, directors, trustees, or employees have rights to conduct the partnership’s business; or
• The organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of directors.

Determination of percentage interest: The Final Regulations retain the rule from the Proposed Regulations that an exempt organization determines its percentage interest in a partnership by taking the average of the exempt organization’s percentage interest at the beginning and at the end of the partnership’s taxable year (or at the beginning and end of the period of ownership within the partnership’s taxable year for a partnership interest held less than a year).

The Final Regulations further provide that for purposes of the de minimis test, an exempt organization’s profits interest is determined in the same manner as its distributive share of partnership taxable income under IRC section 704(b). For purposes of both the de minimis test and the participation test, in the absence of a provision in the partnership agreement, an exempt organization’s capital interest in a partnership is determined on the basis of its interest in the assets of the partnership which would be distributable to the organization upon its withdrawal from the partnership, or upon liquidation of the partnership, whichever is greater.

Consistent with the Proposed Regulations, the exempt organization can rely on the Schedule K-1 (Form 1065 or its successor) it receives from the partnership, as long as the ownership percentage is specifically provided.

Look-through rule: The Final Regulations generally retain the rules from the Proposed Regulations and expand the application of the look-through rule to indirectly-held partnership interests that meet the requirements of the participation test with regards to the immediately higher-tier partnership that owns an interest in that partnership. The participation test for the look-through rule would apply tier-by-tier to the exempt organization’s indirectly held interest. The Final Regulations provide an example of the application of this test.

Grace period: Due to commenters’ concerns, described in the preamble, that a change in ownership could be “entirely due to the actions of other partners,” the Final Regulations provide a grace period that permits a partnership interest to be treated as meeting the requirements of the de minimis test or the participation test, respectively, in the exempt organization’s prior taxable year if certain requirements are met. If an exempt organization meets the requirements, it can treat its interest as a QPI in the taxable year that the change occurs, but the exempt organization would need to reduce its percentage interest prior to the end of the following taxable year to meet the requirements of either the de minimis test or the participation test in that succeeding taxable year for the partnership interest to remain a QPI.

Transition Rule: Consistent with Notice 2018-67 and the Proposed Regulations, the Final Regulations include a transition rule for directly-held partnership interests acquired by an exempt organization before August 21, 2018 (the date of Notice 2018-67). If a partnership interest is not a QPI, but was acquired before August 21, 2018, an organization may treat such partnership interest as a single unrelated trade or business regardless of the number of unrelated trades or businesses directly or indirectly conducted by the partnership. An organization may rely on the transition rule, even if the organization’s percentage interest changes during the transition period. An organization that qualifies for both the transition rule and the look-through rule may apply one but not both.

Organizations may apply the transition rule until the first day of the organization’s first taxable year beginning after the publication of the Final Regulations in the Federal Register.

Rules for QSIs

The Final Regulations further clarify how the QPI rules apply to S corporation interests, including:

• Term substitutions, i.e., “S corporation” for “partnership,”, “shareholder” or “shareholders” for “partner” or “partners” and similar substitutions when applying the de minimis and participation tests, respectively;
• An exempt organization must use its average percentage stock ownership to determine its ownership in an S corporation;
• An exempt organization can rely on the Form 1120S, Schedule K-1, received from the S corporation if the form lists information sufficient to determine the exempt organization’s percentage of stock ownership for the year (a Schedule K-1 that reports “zero” in either the beginning or ending is not sufficient information); and
• A grace period may apply for changes in the exempt organization’s percentage of stock ownership in an S corporation.

Total UBTI and the charitable contribution deduction

The Final Regulations clarify that the charitable contribution deduction is taken against total UBTI calculated under IRC section 512(a)(6)(B).

Public support test

The Final Regulations adopt changes suggested by commenters and permit an exempt organization with more than one unrelated trade or business to determine public support using either its UBTI calculated under IRC section 512(a)(6) or its UBTI calculated in the aggregate.

Treatment of NOLs

The Final Regulations are consistent with the Proposed Regulations and provide that, for taxable years beginning after December 31, 2017, an exempt organization with more than one unrelated trade or business determines the NOL deduction allowed by IRC sections 172(a) and 512(b)(6) separately with respect to each of its unrelated trades or businesses. In addition, the Final Regulations provide guidance on:

1. The treatment of accumulated NOLs upon the sale, transfer, termination, or other disposition of a separate unrelated trade or business, and
2. The treatment of NOLs upon changing identification of a separate unrelated trade or business.

For the treatment of NOLs upon the sale, transfer, termination, or other disposition, the NOL is suspended and can be used in the future if the exempt organization has activities within the silo that the loss was generated. Similarly, upon changes in identification of a separate trade or business, the NOL is kept within the silo that the loss was originally generated.

Additionally, the Final Regulations clarify the ordering for taking into account losses arising in a taxable year beginning before January 1, 2018 (“pre-2018 NOLs”) and losses arising in a taxable year beginning after December 31, 2017 (“post-2017 NOLs”). Specifically, the Final Regulations provide flexibility to allocate a tax-exempt organization’s pre-2018 NOLs to provide an exempt organization the greatest utilization of the post-2017 NOLs in that taxable year.

Subpart F income and global intangible low-taxed income (GILTI)

The Final Regulations adopt the Proposed Regulations, without change, with respect to the rules applicable to inclusions of subpart F income and GILTI.

UBIT for Social Clubs, VEBAs or SUBs

In general, a Social Club within the meaning of IRC section 501(c)(7), a Voluntary Employees Benefit Association within the meaning of IRC section 501(c)(9) (VEBA), or a trust providing supplemental unemployment compensation benefits as described in IRC section 501(c)(17) (SUB) determine UBTI differently from other types of exempt organizations. For these organizations, UBTI is the lesser of the organization’s “investment income” (income from interest, dividends, royalties, rents, and capital gains) or the excess of amounts set aside as of the close of the taxable year over the “account limit” for the year. For purposes of IRC section 512(a)(6), the Proposed Regulations provided that the “investment income” for these organizations is considered derived from investment activities, as well as any amount that was originally set aside but used for a different purpose and any amount set aside in excess of the applicable account limit. The Final Regulations adopt these rules without change.

The Proposed Regulations included additional, special rules applicable to social clubs. The Final Regulations adopt these rules without change.

Qualified plans and individual retirement accounts (IRAs)

The Proposed Regulations provided a special definition of unrelated trade or business for trusts. For this purpose, “unrelated trade or business” means any trade or business regularly carried on by the trust or by a partnership of which such trust is a member. This definition applies to retirement plans that are qualified under IRC section 401(a) and are exempt from taxation under IRC section 501(a). The Proposed Regulations also provided that this definition applies to IRAs that are subject to IRC section 511 by virtue of IRC section 408(e), while also including an affirmative statement that IRAs were subject to UBIT. These rules are also adopted by the Final Regulations without change.

Applicability date

The Final Regulations were published to the Federal Register on December 2, 2020. The Final Regulations are generally effective as of this date and are applicable to taxable years beginning on or after that date. In addition, an exempt organization may choose to apply the Final Regulations under IRC section 512(a)(6), as well as the Final Regulations relating to the calculation of public support, to taxable years beginning on or after January 1, 2018, and before December 2, 2020. Alternatively, an exempt organization may rely on a reasonable, good-faith interpretation of IRC section 512(a)(6) for these taxable years. For this purpose, a reasonable good-faith interpretation includes methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67 or the Proposed Regulations.

With respect to the inclusions of subpart F income or GILTI, a taxpayer may choose to apply the Final Regulations to taxable years beginning before December 2, 2020.

Did you know?

Annual Revenue Procedures Released
The Internal Revenue Service released a series of updated revenue procedures (Rev. Proc.) affecting tax-exempt organizations. Rev. Proc. 2021-1 revises the procedures for letter rulings, user fees, determination letters and information letters on specific issues. Rev. Proc. 2021-2 provides when and how the IRS provides guidance in a technical advice memorandum (TAM). Rev. Proc. 2021-3 updates the list of areas under the Internal Revenue Code that the IRS will not issue rulings. Rev. Proc. 2021-4, contains updated procedures for delivering letter rulings, determination letters, and other advice under the Tax-Exempt and Government Entities Division, Employee Plans Rulings and Agreement Office. Rev. Proc. 2021-5 includes revised procedures for issuing determination letters for organizations not covered under Rev. Proc. 2021-4, private foundation status and other determinations. Rev. Proc. 2021-7 contains a listing of provisions of the Internal Revenue Code that the Associate Chief Counsel (International) will not issue letter rulings or determination letters.

Electronic Filing of Form 4720
Notice 2021-01 provides a delay in the electronic filing requirement for private foundations to file the Form 4720, Return of Certain Excise Tax Under Chapters 41 and 42 of the Internal Revenue Code. The Internal Revenue Service expects a modified paper version of the Form 4720 to be available the beginning of 2021. Private Foundations may continue to paper file the Form 4720 until further guidance is issued. Once the Form 4720 is required to be filed electronically, all such forms filed by a private foundation after such date must be filed electronically. Additionally, the electronic filing will no longer support the ability to have multiple taxpayers (such as disqualified persons) reported on the same Form 4720. The Notice is effective on January 11, 2021.

Electronic Filing of Form 1024-A
Revenue Procedure 2021-08 modifies Revenue Procedure 2021-05 to require organizations to submit the Form 1024-A, Application for Recognition of Exemption Under Section 501(c)(4) of the Internal Revenue, electronically. The Form 1024-A is filed using www.pay.gov. The IRS also provides a 90-day transitional relief period, which the IRS will accept paper versions of the Form 1024-A. To meet transitional relief, the Form 1024-A must be postmarked on or before the end of day on April 5, 2021, which marks the 90-day period starting on the effective date of the Revenue Procedure, January 5, 2021.

Additional Resources

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