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NYSBA Tax Section Submits Report on Proposed UBTI Calculation Regs

Dated July 6, 2020

The New York State Bar Association Tax Section has submitted a report on proposed regulations (REG-106864-18) that provide guidance on how an exempt organization subject to the unrelated business income tax determines if it has more than one unrelated trade or business.

The Tax Section supports the provision in the proposed regs under which business activities conducted directly by an EO or indirectly through a partnership that is not a qualified partnership interest must be reported on the basis of 20 North American Industry Classification System (NAICS) two-digit sector codes. Section members recommend that all EOs that participate in the same unrelated trade or business through one or more passthrough entities be required to report that trade or business consistently. The regs should clarify, however, that EOs can change the NAICS two-digit code for a trade or business if the nature of the business has so evolved or shifted that another NAICS two-digit code more accurately describes the trade or business, the report says.

The Tax Section also agrees that an EO should be able to allocate expenses among multiple trades or businesses using any reasonable basis taking into account all facts and circumstances. Section members believe that no method (including the unadjusted gross-to-gross method) should be deemed per se unreasonable. The report recommends that Treasury and the IRS clarify the method of allocating pre-2018 net operating losses among multiple trades or businesses and suggests two alternatives.

Under the proposed regs, holding debt-financed property (within the meaning of section 514) is treated as an investment activity, but holding interests in partnerships that are controlled entities (within the meaning of section 512(b)(13)) is not. To prevent taxpayers from sidestepping the qualified partnership interest framework, the Tax Section recommends that the definition of debt-financed property be clarified to exclude debt-financed partnership interests that are also controlled entities.

Section members suggest expanding the scope of enumerated investment activities in the proposed regs to include the ownership of some holding company partnership interests. The Tax Section recommends that EOs be required to look through specified partnerships that would otherwise be treated as qualified partnership interests to prevent tiered structures from being used to avoid the limitations on aggregating partnership interests. Members also propose extending the requirement to aggregate partnership interests to interests that are owned by related persons and to EOs that are controlled taxpayers.

The Tax Section generally supports the control test as an administrable method of identifying qualified partnership interests but believes the ownership threshold of the control test should be satisfied if an EO owns less than 20 percent of both the capital and profits interests of a partnership. Moreover, although section members endorse the facts and circumstances approach to evaluate control, they do not think any of the four control rights listed in the proposed regs should be treated as per se evidence of control.

Conservation Easements

The Partnership for Conservation (P4C) has asked the IRS to add to its priority guidance plan (Notice 2020-47, 2020-27 IRB 1) the issuance of rules for conservation easement donations under section 170(h) that provide sample conservation easement grant deed language on which taxpayers can rely.

According to P4C, “Donors have no particular stake in the specific conservation easement grant wording they use. [Their] goal is to preserve land for future generations and obtain the tax benefits Congress provided to incentivize conservation easement donations.” The group notes that donors often use template grant deeds that have been developed by tax practitioners or the Land Trust Alliance. P4C believes “donors would be amenable to reforming grant deed language to conform to IRS guidance — particularly language dealing with remote events that are unlikely to ever occur — if given the opportunity to do so.”

The organization cites two examples of conservation easement grant deed language that affect most conservation easement donations made in the last several years. The first is the proceeds clause, which requires that the conservation easement be perpetual. P4C observes, however, that existing regulations do not address how to divide condemnation or casualty proceeds if a landowner makes improvements to the land after the date of donation. The second example involves amendment clauses in easement deeds, which provide the ability to amend the deed and thereby protect the conservation purposes. According to the group, the IRS has recently taken the position that the presence of a clause allowing an amendment invalidates the deduction.

To address those issues, P4C suggests that the IRS work with interested organizations and tax practitioners to develop template conservation easement grant deed language that the IRS would agree satisfies the applicable requirements under section 170(h). Similarly, the national taxpayer advocate’s 2019 report to Congress recommended that to mitigate disputes, the IRS should “develop and publish guidance to provide safe harbors and/or sample easement provisions to provide taxpayers with examples of how they may construct a conservation easement deed that satisfies the statutory requirements and prevents unnecessary litigation.”

P4C says its recommended conservation easement grant template language would resolve significant issues relevant to a broad class of taxpayers. Specifically, the group says the proposed language would reduce controversy, lessen the burden on taxpayers and the IRS, and promote sound tax administration. Moreover, the template relates to existing regulations that are unnecessarily burdensome, can be administered by the IRS on a uniform basis, and can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance, P4C says.

Valuation Misstatement Penalty

The American Society of Appraisers and 10 other valuation professional organizations have expressed concern that a recent change to the Internal Revenue Manual regarding valuation misstatements “replaces a meaningful and robust process that worked to equitably ensure the legitimacy of claims brought by the IRS under 6695A with a truncated and more arbitrary process where a valuation misstatement penalty or referral to the Office of Professional Responsibility can be acted upon without regard to essential due process protections for valuation professionals.”

The organizations argue that the new process by which the IRS considers whether a valuation professional has violated the misstatement provisions of section 6695A is not only contrary to the notions of due process and administrative restraint, but also places too much control and responsibility “in the hands of examiners or attorneys who may lack any formal valuation training or specialized knowledge as to the subjects of the underlying valuation without a clear process for introducing relevant expertise into the review.”

The groups warn that the new system is inferior for several reasons. First, they contend that without the checks and balances of the original process, in which more than one valuation professional and a review panel would consider the appraisal in question to determine whether a violation of section 6695A had occurred, the number of cases brought without merit will likely increase, especially those with no referral from an examining appraiser. This will require many valuation professionals to unnecessarily invest significant time, money, and emotional capital to defend themselves against an allegation, the appraisers say.

Second, if an examiner cannot be convinced that the conclusion reached by the valuation professional was more likely than not supported, the appraiser will have to decide whether to lodge an appeal, and thereby incur additional burdensome costs, or to accept the finding and the likelihood that the ability to practice before the IRS will be severely limited if not ended. The valuation groups emphasize that appraisals are not facts to be uncovered but matters of opinion, and that the IRS should not lower the standard for imposing the penalty by having only one valuation examiner involved and no review panel.

Third, the original process required five individuals (a revenue agent or attorney, his manager, the engineering valuation penalty manager, and two independent IRS appraisers) to review the potential of the case before contacting the appraiser for an examination. The valuation groups point out that one reason this process was implemented was “to prevent frivolous allegations by agents or attorneys that may have personal issues with the taxpayer or taxpayer’s appraiser stemming from prior interactions.” The original process required the involvement of “unbiased, trained professionals that understood the valuation theory and had the experience to understand the valuation issues,” they say, adding that “the panel allowed a determination of which cases truly were egregious.”

Lastly, the valuation organizations object to the way the new process was implemented without any stakeholder notice or engagement. The groups claim they are writing “not to simply critique the new review process, but to encourage the Service to work collaboratively with the valuation profession to find a way forward that maintains the rigor that existed under the previous review program while addressing resource constraints and other issues that led to the recent change.”

Coronavirus-Related Correspondence

The American Institute of CPAs has requested additional guidance and relief regarding section 461(l), which was amended by the Coronavirus Aid, Relief, and Economic Security (CARES) Act (P.L. 116-136) to suspend the otherwise applicable limitations on excess business losses for noncorporate taxpayers during the period from 2018 to 2020. However, for tax years beginning after December 31, 2020, and before January 1, 2026, excess business losses for taxpayers other than C corporations are generally disallowed.

The AICPA suggests that taxpayers who reported excess business losses for the 2018 tax year should have the opportunity to adjust their section 461(l) loss without amending their tax returns. Taxpayers electing under section 172(b)(3) to waive the NOL carryback period should only have to adjust the NOL carryforward to reflect the additional business loss resulting from the removal of the section 461(l) disallowed loss, the institute says. The CPAs also seek related interest and penalty relief for underpayment of estimated taxes.

On the same topic, 75 organizations wrote to leaders of the Senate Finance Committee that the NOL provisions in the CARES Act allowing a five-year carryback and suspending excess business loss limitations permit taxpayers to use NOLs to a greater extent to offset taxable income in prior or future years to provide taxpayers with liquidity in the form of tax refunds and reduced current and future tax liability. The groups say the CARES Act provisions “are helping to ensure that the severe economic situation created by COVID-19 does not become even worse.”

In a letter to leaders of the House and Senate, 130 organizations expressed support for legislation to expand the employee retention tax credit to provide businesses with a financial incentive to keep workers on the payroll when business operations are fully or partially suspended because of COVID-19-related closing orders or when a company’s gross receipts significantly declined compared to the same quarter last year.

Julie Brienza, Andy Sheets, and Emily Vanderweide contributed to this column.

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