UBTI Guidance Makes Compliance Next to Impossible, Firm Says

December 3, 2018

Ms. Stephanie N. Robbins
Mr. Jonathan A. Carter
Internal Revenue Service
CC:PA:LPD:PR (Notice 2018-67), Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Notice 2018-67

Dear Ms. Robbins and Mr. Carter:

Thank you for the opportunity to provide comments regarding the calculation of unrelated business taxable income (“UBTI”) under Section 512(a)(6)¹ for tax-exempt organizations that have or may be considered to have more than one unrelated trade or business.

We write on behalf of our clients who are concerned that the interim rules set forth in Notice 2018-67 (the “Notice”) do not provide an administrable framework and impose an undue burden that will make compliance very difficult, if not impossible, particularly with respect to income from non-controlled partnerships and any required attribution of ownership from “disqualified persons.”

As discussed below, the reasons for the administrative burden under the interim rules are several:

• First, the interim rules' definition of control of a partnership is too restrictive and deems investors to control a partnership at ownership levels far below the requisite level that would enable an investor to access sufficient information to comply with the Section 512(a)(6). More importantly, the interim rule's definition of control is inconsistent with actual industry practices that have developed over time in reliance on the Delaware Limited Partnership Act and the common law to determine whether an investor controls a partnership. As a result, the definition of control of a partnership in the interim rules makes compliance with the application of Section 512(a)(6) to UBTI that flows up from investments in trades or businesses held directly or indirectly in partnerships impracticable or impossible.

• Second, the requirement to combine the percentage ownership of disqualified persons with those of an exempt organization creates an enormous administrative burden and should be struck from forthcoming regulations. Rules requiring exempt organizations to track disqualified person ownership in investment partnerships defy compliance because a broadly diversified endowment may have hundreds of partnership investments and hundreds of disqualified persons, due to the expansive definition of disqualified persons, which leads to a requirement that an exempt organization continuously monitor tens of thousands of potential investment and disqualified person ownership combinations.

• Third, the interim rules utilize an overly broad definition of “trade or business” that could be interpreted to treat investment partnerships that only have UBTI from acquisition indebtedness of investment assets as multiple trades or businesses, each requiring separate computation under Section 512(a)(6). Under the interim rules, tracing, separate computation, and tracking of UBTI is, therefore, theoretically limitless. Moreover, the overly broad definition of “trade or business” in the interim rules is inconsistent with the statutory definition of “trade or business” for purposes of UBTI in Section 513(c), which only includes income from the sale of goods or services, and excludes investment income. The proposed regulations should provide that only UBTI from the sale of goods or services is computed separately, and all other UBTI is computed together.

By requesting comments on these topics, the Notice acknowledges that these are critical issues to resolve prior to proposing an administrable set of implementing regulations, and we are pleased to provide input for your consideration in crafting further guidance.

As discussed below, there are straightforward, practical, and administrable solutions to each of these issues that are grounded in the tax policy and jurisprudence of the unrelated business income tax (“UBIT”) and law applicable to investments held in partnerships.

Specifically, we recommend that future guidance only require separate computation of UBTI from an unrelated trade or business held in a partnership if the UBIT-paying organization directly or indirectly controls the underlying trade or business giving rise to the UBTI — as opposed to the interim rules' requirement to measure an exempt organization's control solely based on direct ownership of a partnership with UBTI.

We further recommend that control of the trade or business should be determined by whether the investor has limited liability protection with respect to the trade or business under applicable law. If a UBIT-paying organization has limited liability with respect to the trade or business giving rise to the UBTI, then the organization should not be considered to control that trade or business, and, therefore, UBTI arising from that trade or business should not be separately computed under Section 512(a)(6). If, however, the UBIT-paying organization does not have limited liability with respect to the underlying UBTI-generating trade or business, then the organization should be treated as controlling that trade or business and, therefore, should be required to compute UBTI separately with respect to that trade or business under Section 512(a)(6).

To be clear, this proposed definition of “control” would permit holdings of the economic value of a trade or business that are north of 50% without requiring separate computation of UBTI, provided that the investor has limited liability with respect to that trade or business. By the same token, however, our proposed definition of “control” would also capture situations in which an investor has less than 50% of the economic value of the trade or business but holds a general-partner interest or exercises a level of control under applicable law that would lead to general liability. We believe this definition is therefore not only administrable because an investor should always know whether or not liability is limited, but also fair because it encapsulates qualitative factors indicating control into a simple “yes-or-no” analysis.

In the alternative, should the forthcoming guidance decline to use the limited liability test for “control,” we would recommend a definition of control that looks to whether the UBTI-paying investor in a partnership has the sole power to appoint the general partner or majority of the board of governors of the entity operating the trade or business giving rise to the UBTI, measured on a direct or indirect basis. We would recommend coupling such a test for control with a safe harbor that excludes partnerships of which the UBIT-paying investor directly or indirectly owns 50% or less of the profits interest of the entity operating the trade or business giving rise to the UBTI. The 50% threshold for “control” has statutory precedent in the context of the UBIT under Section 512(b)(13)(D)(i), which defines UBTI from payments by entities controlled by the exempt organization receiving the payment. Under this approach, a UBTI-paying organization would compute UBTI separately for each trade or business of which it holds more than 50% of the beneficial interests and with respect to which it has the unilateral power to appoint the general partner or majority of the board of governors. In addition, if forthcoming guidance includes a requirement that qualitative factors are considered in the evaluation of control of a partnership, that guidance should provide that an investor is presumed not to have control or influence over partnership merely by exercising any rights that the investor is permitted to exercise while maintaining limited liability status in a partnership.

We further recommend that the proposed regulations not require attribution from disqualified persons associated with the UBIT-paying organization. Finally, we recommend that for purposes of Section 512(a)(6), the proposed regulations utilize the existing definition of “trade or business” in Section 513(c) that includes income from the sale of goods or services and excludes investment income, including debt-financed income, and that only UBTI from the sale of goods or services should be computed separately, with all other UBTI computed together.

I. UBIT from a Controlled Trade or Business Held in a Partnership

The primary issue we wish to address in these comments is the treatment of UBIT from trades or businesses held in partnerships under Section 512(a)(6).

By way of background, Section 512(a)(6) provides a “special rule” for applicable organizations with two or more unrelated trades or businesses that requires such organizations to compute UBTI separately for each trade or business.

In the case of any organization with more than 1 unrelated trade or business —

If the trade or business that gives rise to UBTI is held in a partnership, however, the question that arises is how to identify the UBTI with the underlying trade or business that generated it. Such identification is necessary because the partnership may well have a different trade or business from the UBTI-generating trade or business, or it may have multiple trades or businesses. The regulatory interpretation of Section 512(a)(6), therefore, should adopt a “bottom-up” rather than a “top-down” approach to identifying the trade or business for separate computation of UBTI. In other words, future guidance should measure the UBIT-paying organization's control of the UBTI-generating trade or business itself, not solely the organization's direct control of a partnership that indirectly holds the UBTI-generating business.

Top-down measurement leads to the wrong result when a UBIT-paying organization makes an investment into a structure with multiple layers of holding companies and partnerships prior to reaching an entity that is taxed as a partnership and that generates UBTI through an operating business. Measuring the percentage ownership of an exempt organization for the control test solely based on its direct ownership of a partnership could in many instances lead to inequitable results where “control” of an investment is attributed to an exempt organization when in reality the exempt organization's ownership of the entity that operates the UBTI-generating trade or business does not give it real-world control due to ownership dilution from a multilayer investment structure. Adoption of a standard that permits measurement of ownership on an indirect “pass-through” basis is fair, equitable and reasonable because it would treat the ownership attribute consistently with the pass-through treatment of income, deductions and other tax attributes that are passed through multiple layers of partnerships to the ultimate tax-paying partners.

The key consideration in implementing an administrable rule is the UBIT-paying partner's access to information about the underlying trade or business. Investors in partnerships where they have no control generally have very little information regarding the source of UBTI flowing up from the partnership, which makes compliance with Section 512(a)(6) challenging if not impossible. This is because a partnership's investment strategies and financial information are typically confidential and unavailable to investors in sufficient detail to enable compliance with Section 512(a)(6) without undue burden. The Form 1065 Schedule K-1 is very little help because it reports UBTI on an aggregate basis rather than on a separate trade or business basis in Box 20 code V. As a result, it is generally impossible for investors in partnerships to determine the ultimate source of the UBTI and use that information to comply with Section 512(a)(6).

The same should not be true, however, of investors who directly or indirectly control the trade or business giving rise to the UBTI. These investors should have information about the trade or business they control. For this reason, and as discussed further below, the proposed regulations should only require separate computation of UBIT derived from an unrelated trade or business held in a partnership if the UBIT-paying organization itself directly or indirectly controls the trade or business that generates the UBTI.

The following discussion proposes a simple means of identifying when a UBIT-paying organization controls the trade or business giving rise to the UBTI, even when that trade or business is submerged in a lower-tier partnership.

A. Limited Liability Test

A partnership interest should be treated as a “qualifying partnership interest,” with the effect that UBTI earned in that partnership not be subject to separate computation under Section 512(a)(6), if and only if the UBIT-paying organization has limited liability as an investor with respect to the underlying trade or business giving rise to the UBTI. Such a test would be simple to administer because every investor knows, or should know, whether or not its liability is limited with respect to an investment by using basic due diligence. The limited liability test is binary and objective — either there is limited liability or there is not — and involves information that the investor should have readily available; yet the test also synthesizes a great deal of qualitative information as numerous state law factors affect whether an investor is entitled to limited liability. Most important, if an investor does not have limited liability with respect to a trade or business, then the investor should have sufficient information about that trade or business with which to comply with the separate computation rules of Section 512(a)(6).

The interrelationship between control over a partnership and limited liability of the partner has a long common law and statutory history. For example, Section 17-303 of the Delaware Limited Partnership Act states that “[a] limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner or, in addition to the exercise of the rights and powers of a limited partner, he or she participates in the control of the business.” Section 17-303(b) of the Delaware Limited Partnership Act then enumerates a substantial list of actions, many of which could be interpreted to conflict with the standards set forth in the interim rule, that limited partners can undertake that would not be considered to be taking part in the control of the partnership and jeopardize a partner's limited liability status.

Various uniform partnership and limited liability company acts and other jurisdictions' partnership, limited liability company and similar laws contain similar principles. For example, pursuant to partnership agreements and equivalent governing documents for other entity types, many investment partnerships (or other entities) (a) do not permit investors to remove a general partner or governing body without cause; (b) restrict the removal of a general partner or a governing body only if such persons or entities have acted in bad faith, been grossly negligent, or have committed other “bad acts” with no ability to remove such persons and entities for any other reason; or (c) set consent requirements for removal of the general partner or governing body with or without cause at capital interest levels significantly greater than 50%, such as 66 2/3%, 75% or greater. The result of these types of contractual provisions is that in many instances, even if an investor owns over 50% of the capital interests in such entity, the investor has no control rights in such entity. Effectively, the range of investments from a de minimis capital interest to a capital interest that would permit an investor to change the general partner unilaterally or other governing body unilaterally are all equally passive investments.

By adopting this limited liability standard, both the exempt organization and the IRS would have an objective and clearly defined means of measuring control, which should greatly reduce the interpretative and administrative burden on the IRS and exempt organizations of complying with Section 512(a)(6). Moreover, such an approach would lead to consistent application of principles across tax and governance law and would permit an exempt organization to continue to exercise its ordinary-course noncontrol rights without the potential of having to reach a different conclusion as to control under tax law.

On the other hand, a split in interpretation between state law and tax law regarding “control” of a trade or business held in a partnership would introduce significant administrative and operational costs on exempt organizations, as routine and frequently negotiated governance rights would need to be evaluated both for business purposes and for their potential effects under tax law. Such a split in interpretation would likely introduce unnecessary and avoidable tax inefficiency.

For example, many of the actions listed Section 6.03(3) of the Notice deem control or influence to occur if an exempt organization may require or prevent the partnership from undertaking an action “or if the exempt organization has the power to appoint or remove any of the partnership's officers, directors, trustees or employees.” These concepts of control are too broad and are in direct conflict with the rights investors are permitted to exercise while maintaining limited liability under longstanding statutory and common law. The potential uncertainty in the standards proposed in the Notice would be unworkable in practice.

B. Alternative 50% Safe Harbor

We believe the limited liability standard proposed above is the more administrable approach to defining control of a trade or business held in a partnership for purposes of Section 512(a)(6). If, however, this approach is not adopted, then we would propose that an organization be deemed to control a trade or business held in a partnership only if the organization has the ability to unilaterally appoint the general partner or the majority of the governing body of the partnership holding the trade or business.

We would also propose a safe harbor in which organizations holding a direct or indirect capital interest of 50% or less in the partnership that holds the unrelated trade or business should be presumed not to control the partnership. A UBIT-paying organization that holds a capital interest of less than 50% in a partnership that holds the unrelated trade or business giving rise to the UBTI should only be treated as controlling such entity, however, if it is the general partner or has the power unilaterally to appoint the general partner of a partnership or the majority of the governing body.

There is ample statutory authority for a 50% threshold that is specific to the context of UBIT. For example, Section 512(b)(13)(D) defines “control” for purposes of identifying payments from controlled entities that give rise to UBTI to mean ownership (by vote or value) of more than 50% of the stock or other ownership interest in a nonstock entity, and it applies the constructive ownership rules of Section 318 to determine indirect control through attribution from other entities. These rules are designed for the UBTI statutory framework and have the identification of a controlled trade or business as their primary purpose. We, therefore, commend them to you for use in constructing any numerical test for determining control under Section 512(a)(6). By contrast, the lower-percentage thresholds found in Section 4943 (excess business holdings of a private foundation) or other Code sections that define “control” are irrelevant to the present context and should not be used to guide the regulations under Section 512(a)(6).

In addition, if future guidance includes a requirement that qualitative factors be considered in the evaluation of control of a partnership, for the reasons set forth in our proposal for use of a limited liability test, we recommend that guidance be issued stating that there is no presumption of control or influence over a partnership if an investor exercises its rights or takes actions that it is permitted to take while maintaining its limited liability status in a partnership.

II. Disqualified Person Attribution

The Notice proposes to measure not only the UBIT-paying organization's interest in a partnership but also the interests of its disqualified persons, supporting organizations, and controlled entities in the same partnership.

Disqualified person attribution is profoundly unadministrable and should be reserved only for situations that absolutely require it — safe harbors not being among them. Requiring an organization to track the investments of its trustees, directors, officers, key employees and others “in a position to exercise substantial influence over the affairs of the organization”² along with such persons' extended familial relations, such as children, grandchildren, siblings and spouses of the foregoing during the previous five-year period, and then matching that data with the organization's own investment holdings is a daunting — and likely impossible — task. The expansive definition of disqualified persons leads many exempt organizations to have hundreds of individuals covered by this definition while prudent portfolio management of a tax-exempt entity's diversified endowment can result in hundreds of partnership investments. Simple multiplication of these two large sets of inputs leads to the requirement that many exempt organizations would need to continuously monitor tens of thousands of possible combinations of partnership investments and disqualified persons. This enormous, if not impossible administrative burden, substantially outweighs any possible benefit of requiring such attribution. We, therefore, recommend that future guidance remove the requirement that an exempt organization attribute its disqualified persons' ownership of a partnership with its ownership of a partnership.

III. Definition of “Trade or Business” Excludes Investment Activity

The definition of “trade or business” is critical to the proper interpretation and application of Section 512(a)(6) for several reasons. First, the statute only applies to organizations with “more than one” unrelated trade or business,” so, as a definitional matter, the identification of a “trade or business” is important. Second, the statute requires separate computation for “each such trade or business” but does not, on its terms, require separate computation for all UBTI. Third, and most importantly, the definition of “trade or business” informs — and, we believe, significantly narrows — the scope of the implementing regulations because it excludes investment income, as discussed further below.

By focusing the regulations on UBTI from a trade or business involving the sale of goods or services and excluding UBTI from investment activity, the regulations should permit all UBTI that is not derived from the sale of goods or services (including debt-financed income) to be computed together rather than separately. Future regulations thus can avoid many of the complexities that arise from efforts to separately compute UBIT earned in investment partnerships.

The exclusion of investment income from the definition of “trade or business” further supports the proposal to identify trades or businesses held in partnerships using the limited liability approach or alternative 50% safe harbor approach described above because the vast majority of investment partnerships have UBTI from debt-financed income rather than income from the sale of goods or services.

A. “Trade or Business” Under Section 513(c)

The Internal Revenue Code supplies a definition of “trade or business” that is specific for UBIT— namely, Section 513(c), which provides that:

For purposes of this section, the term “trade or business” includes any activity which is carried on for the production of income from the sale of goods or the performance of services.

This definition of “trade or business” only includes the production of income from the sale of goods or the performance of services; it excludes the production of income from investments. The regulations under Section 512(a)(6) should incorporate this definition of trade or business as well.

The exclusion of investment income from “trade or business” is consistent with the UBIT regime, which generally excludes investment income pursuant to the modifications of Section 512(b). It is also consistent with the common law and general tax principles, which do not classify investment activity as a trade or business. See, e.g., Higgins v. Comm'r., 312 U.S. 212, 218 (1941) (investing on one's own account is not a trade or business); Treas. Reg. § 1.864-2(c)(2) (defining “engaged in trade or business within the United States” to exclude “the effecting of transactions in the United States in stocks or securities for the taxpayer's own account,” irrespective of whether such transactions are effected by or through the taxpayer itself, its employees, or a broker, commission agent, custodian, or other agent of the taxpayer).

B. UBTI from Investment Income

The fact that an item of income is subject to UBIT does not entail that the income derives from a “trade or business.” Certain types of investment income are subject to UBIT despite not being income from a “trade or business” because of special statutory rules designed to achieve policy objectives unrelated to the accurate measurement of an organization's income from an unrelated trade or business.

These include Section 514 which treats investment income from assets acquired with debt as subject to UBIT in order to prevent the 1950s-era “Clay-Brown” tax shelter involving leveraged sale-leaseback transactions (which are no longer a concern due to other antiabuse provisions in the Code) and Section 512(b)(13), which treats investment income from a controlled corporation as subject to UBIT in order to prevent transfer pricing abuse, even if the transaction is at fair market value.³ Other examples include investment income from an S corporation under Section 512(e) and investment income from insurance under Section 512(b)(17) that is not previously taxed by the taxpayer that earned it and, therefore, would escape taxation were it not for UBIT. In addition to “non-trade or business” investment income, there is also one category of expense that is subject to UBIT, namely that Section 512(a)(7) taxes qualified parking and transportation fringe-benefit expenses.

These statutory overrides to UBIT underscore the point that the types of income they describe do not, in fact, derive from a trade or business; otherwise, the statutory override would not be needed. For example, Section 512(b)(4) uses the special terminology set forth in Section 514 to treat debt-financed income as though it were an “item of gross income derived from an unrelated trade or business,” thereby confirming that debt-financed income is not trade or business income.

Notwithstanding paragraph (1), (2), (3), or (5), in the case of debt-financed property (as defined in section 514) there shall be included, as an item of gross income derived from an unrelated trade or business, the amount ascertained under section 514(a)(1), and there shall be allowed, as a deduction, the amount ascertained under section 514(a)(2).

Similarly, Section 512(b)(13) describes the UBIT income inclusion as “a specified payment from another entity which it controls” and treats such a 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).” This confirms that such “specified payments” from a controlled entity — which include investment income such as interest, rent, royalties, and the like — are not trade or business income. The UBIT inclusion of Section 512(a)(7) qualified parking and transportation fringe-benefit expenses underscores the point that not all UBIT derives from a “trade or business” and, even further, as an expense, it can never be considered income from a “trade or business” under any conceivable definition.

These statutory overrides of UBIT do not change the definition of trade or business; rather, they change the treatment of certain items of nontrade or business income and expense, including certain items of investment income, to cause them to be subject to UBIT when they otherwise would not be. That is well enough for UBIT; however, it is not sufficient to make those items of UBIT subject to Section 512(a)(6), which only applies to “trade or business” income.

C. Risks of Chevron Challenge

It would be improper for regulations interpreting Section 512(a)(6) to utilize a definition of “trade or business” that includes investment income because Section 513(c) supplies a definition of “trade or business” for UBIT purposes that excludes investment income. Where Congress has “directly addressed the precise question at issue,” there is no room for a regulatory interpretation that achieves a different result. Chevron U. S. A. Inc. v. Nat. Res. Defense Council, Inc., 467 U. S. 837, at 842–43 (1984). Regulations under Section 512(a)(6) should adopt this definition of “trade or business” because the statute requires it.

Regulations under Section 512(a)(6) should require UBTI from trades or businesses involving the sale of goods or services to be computed separately, but should permit UBIT arising from investment income to be computed together, regardless of whether such investment income is debt-financed.

This approach is not only the better statutory interpretation, but it also would achieve significant gains in administrability of the statute. As discussed above, investment income is not income from a “trade or business.” Debt-financed income is not itself a trade or business, or even a distinct category of activity arising from a particular trade or business, and acquisition indebtedness does not convert investment income into trade or business income; rather, acquisition indebtedness just makes investment income taxable.

If the source of funds used to acquire an asset were to cause the income produced by the asset to become a "trade or business" for purposes of Section 512(a)(6), then the number of trades or businesses that an organization would need to track and compute separately would be as large as the number of income-producing assets it could acquire — a theoretically infinite number. This is not workable and demonstrates why investment income should not be subject to Section 512(a)(6), regardless of whether the investment asset is or is not acquired with debt.

* * *

We hope that these comments are helpful to you as you formulate proposed regulations under Section 512(a)(6). We would be happy to speak with you or provide further clarification or input on the information discussed above. Thank you for your consideration.

Sincerely,

Alexanader L. Reid
Morgan Lewis
Washington, DC

Copy to:

Treasury

David Kautter, Assistant Secretary for Tax Policy
Stephen LaGarde, Attorney-Advisor, Office of Benefits Tax Counsel
Elinor Ramey, Attorney-Advisor, Office of Tax Policy
Krishna P. Vallabhaneni, Acting Tax Legislative Counsel

Internal Revenue Service

Robert Choi, Acting Deputy Commissioner
Janine Cook, Deputy Associate Chief Counsel, Tax Exempt & Government Entities
David Horton, Acting Commissioner for Tax Exempt & Government Entities
Victoria Judson, Associate Chief Counsel, Tax Exempt & Government Entities
William M. Paul, Acting Chief Counsel and Deputy Chief Counsel
Charles Rettig, Commissioner
Drita Tonuzi, Deputy Chief Counsel for Operations

Morgan Lewis & Bockius LLP

Celia Roady