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California Lawyers Association Seek Clarification of UBTI Guidance

DEC. 3, 2018

California Lawyers Association Seek Clarification of UBTI Guidance

DATED DEC. 3, 2018
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December 3, 2018

Internal Revenue Service
CC:PA:LPD:PR (Notice 2018-67), Room 5203
P.O. Box 7604
Ben Franklin Station
Washington. DC 20044

Email: Notice.Comments@irscounsel.treas.gov

RE: Comments on Notice 2018-67

Members of the Taxation Section of the California Lawyers Association (“CLA”) are pleased to submit these comments on Notice 2018-67, regarding the calculation of unrelated business taxable income under section 512(a)(6) for exempt organizations with more than one unrelated trade or business; interim and transition rules for aggregating certain income in the nature of investments; and the treatment of global intangible low-taxed income inclusions for purposes of the unrelated business income tax.

These comments were prepared by Matthew A. Clausen and Geena Yu, members of the Taxation Section's Exempt Organizations Committee. They were reviewed by Annette Nellen, Special Advisor to the Taxation Section, Shirley McLaughlin, Chair of the Taxation Section's Exempt Organizations Committee, and Karl Mill, member of the Taxation Section's Exempt Organizations Committee. These comments represent the individual views of the authors who prepared them, and do not represent the position of the CLA or the Taxation Section.

Although the members of the Section of Taxation who participated in preparing these Comments have clients who might be affected by the federal income tax principles addressed by these Comments, no such member or firm or the organization to which such member belongs has been engaged to make a government submission with respect to, or otherwise to influence the development or outcome of, the specific subject matter of these Comments.

We appreciate your consideration of these comments. If you would like to discuss these issues further, please feel free to contact Matthew A. Clausen at (415) 421-7555 or matt.clausen@adlercolvin.com; or Geena Yu at (562) 884-5690 or geenayu5@gmail.com.

Sincerely,

Troy Van Dongen
Chair, Taxation Section of the California Lawyers Association
San Francisco, CA

cc:
The Honorable David J. Kautter, Assistant Secretary for Tax Policy, Department of the Treasury
The Honorable Charles P. Rettig, Commissioner, Internal Revenue Service
Mr. William M. Paul, Acting Chief Counsel, Internal Revenue Service


 California Lawyers Association

Section of Taxation

Comments on Notice 2018-67 Regarding the Calculation of Unrelated Business Taxable Income under § 512(a)(6) for Exempt Organizations with More than One Unrelated Trade or Business; Interim and Transition Rules for Aggregating Certain Income in the Nature of Investments; and the Treatment of Global Intangible Low-Taxed Income Inclusions for Purposes of the Unrelated Business Income Tax

I. Summary of our Recommendations

The authors respectfully recommend the following:

  • Permanent guidance should provide a general facts and circumstances test with at least one clearly-defined safe harbor for segregating separate trades or businesses. One safe harbor should be based on the first two digits of the NAICS code, representing 20 industry sectors.

  • Permanent guidance should also describe circumstances in which combining income and deductions from activities from separate NAICS codes would be considered reasonable under the general facts and circumstances test.

  • Income treated as unrelated business income (“UBI”) under sections 512(b)(4), (13), and (17) is typically income from an investment portfolio and not associated with a trade or business and should be excluded from the requirement of section 512(a)(6).

  • If income under sections 512(b)(4), (13) and (17) is not excluded from 512(a)(6), then it should be aggregated in a single silo for investment-related UBI, which would also include any income allocated to the organization from a partnership or other pass-through entity that the organization does not control.

  • For purposes of the de minimis test for partnership interests, an exempt organization should be allowed up to 90 days to reduce its interest if its percentage interest increased over 2% as a result of another partner's withdrawal or percentage reduction.

  • For purposes of the control test for partnership interests, control should be defined as ownership of more than 50% of the profits or capital interests in a partnership.

  • For purposes of both the de minimis and the control tests, interests of disqualified persons should not be aggregated with the exempt organization's partnership interests.

  • The language of the transitional rule should make clear that it applies to partnership interests acquired before August 21, 2018 regardless of any subsequent capital contributions.

  • Permanent guidance should clarify that exempt organizations can apply historic net operating losses (“NOLs") to UBTI before applying post-2017 NOLs.

DISCUSSION

II. Background

These Comments respond to the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) request for comments on the regulatory implementation of section 512(a)(6)1 set forth in Notice 2018-67 (the “Notice”).

Exempt organizations are generally subject to taxation on their net income from unrelated trades or businesses. Historically, exempt organizations have been permitted to aggregate their income, gains, and losses from all their unrelated business activities in calculating their unrelated business taxable income (“UBTI”).

New section 512(a)(6), added by the Act,2 changed the calculation. Aggregation across multiple unrelated trades or business is no longer permitted. Instead, an organization must calculate its UBTI for “each such trade or business.”3 Section 512(a)(6), reads as follows:

SPECIAL RULE FOR ORGANIZATION WITH MORE THAN 1 UNRELATED TRADE OR BUSINESS. — In the case of any organization with more than 1 unrelated trade or business —

(A) unrelated business taxable income, including for purposes of determining any net operating loss deduction, shall be computed separately with respect to each such trade or business and without regard to subsection (b)(12),

(B) the unrelated business taxable income of such organization shall be the sum of the unrelated business taxable income so computed with respect to each such trade or business, less a specific deduction under subsection (b)(12), and

(C) for purposes of subparagraph (B), unrelated business taxable income with respect to any such trade or business shall not be less than zero.

The rule of section 512(a)(6) has been dubbed as the “silo rule” because it requires an organization to segregate its gross income minus allowable deductions (including any NOLs) into separate “silos” for each trade or business it conducts.4 An organization's UBTI is the sum of the taxable income for each silo.

The Notice recognizes that the silo rule is potentially difficult to administer for an exempt organization and also for the Service. In particular, regulatory guidance is necessary to define the phrase “each such trade or business” so that it is clear how income, gain, and losses should be segregated into silos, as the rule requires. These comments provide our views and recommendations on that core issue, as well as other issues identified in the Notice.

III. Comments on Specific Sections of the Notice

The Notice requests comments on a number of issues related to the application of section 512(a)(6). We address issues below in the order they are presented in the Notice.

A. Notice Section 3 — Separate Trade or Business

We welcome the interim rule instituted under Section 3.02 of the Notice. The interim rule is helpful as temporary guidance to assist organizations in deciding how to approach section 512(a)(6). The general approach of the interim rule — a general facts and circumstances test with a clearly defined safe harbor — is a sensible approach that provides both a bright line test and the flexibility for organizations to diverge from that bright line where it is reasonable to do so given the organization's own particular circumstances.

We believe the general approach of the interim rule is appropriate for permanent guidance. A pure facts and circumstances test is not appropriate for the reasons described in Section 3.03 of the Notice. Further, without a published safe harbor, the Service would likely have to develop its own audit guidelines for what approaches to the silo rule are reasonable in which circumstances if there is to be any hope of consistent treatment for similarly-situated organizations. Thus, a published safe harbor will make any permanent guidance both more administrable and more equitable than a pure facts and circumstances test.

As to the safe harbor itself, we agree with the use of the NAICS coding system, but recommend a broader version than that in the interim rule. Referencing NAICS codes is a sensible approach given that Form 990-T already requires organizations to classify their unrelated business activities using these codes.5 However, requiring the use of all six digits in order to use the safe harbor would result in over one thousand potential silos, likely causing many organizations to diverge from the safe harbor in order to combine income and deductions along more logical lines based on their actual business activities and shared expenses. This would reduce the value of a safe harbor and effectively reduce the test to pure facts and circumstances for many organizations, with the negative attendant implications.

We agree with other commentators that have recommended a safe harbor based on fewer digits of the NAICS codes, preferably the first two digits, representing a total of 20 industry sectors.6 We believe silos based on the two-digit codes would provide sufficient separation between truly different business activities to achieve the purposes underlying Congress' enactment of section 512(a)(6), while making the safe harbor more attractive, likely improving compliance, and making the rule more administrable for the Service. If instead Treasury and the Service determine that a permanent NAICS-based safe harbor should require using more than the initial two digits of each code, then we recommend an explicit statement in the permanent guidance that using fewer digits is not presumptively unreasonable under the general facts and circumstances test.

We also recommend that permanent guidance describe particular circumstances where combining income and deductions from activities from separate NAICS codes would be considered reasonable under the general facts and circumstances test. The provisions of Regulations section 1.132-4(a)(3) appear to provide a model for guidance along these lines.7

Finally, in addition to broadening the NAICS code-based safe harbor as described above, we also recommend providing for the possibility of additional safe harbors to be created under published rulings or other guidance. For example, the Service and Treasury may over time determine certain circumstances where certain categories of business activity occurring at the same physical location should be treated as a single silo, regardless of NAICS code, and may wish to publish an additional safe harbor under binding guidance such as a revenue procedure. We recommend that permanent guidance leave the option open for additional safe harbors without requiring the promulgation of further regulations.

B. Notice Section 4 — Income Treated as an Item of Gross Income from an Unrelated Trade or Business

Section 4 of the Notice addresses income treated as UBI under section 512(b)(4), (13), and (17). In our experience, these types of income almost always arise in the context of an organization's investment portfolio, not from a trade or business, and thus these types of income should, except in rare cases, be excluded from the provisions of section 512(a)(6). The Supreme Court ruled long ago that investing for one's own account is not a trade or business for purposes of the business expense deduction.8 As stated in the regulations, “for purposes of section 513 the term trade or business has the same meaning it has in section 162, and generally includes any activity carried on for the production of income from the sale of goods or performance of services."9 Investing for one's own account does not fit this description, since it is not treated as a trade or business for purposes of section 162 and is not the sale of goods or performance of services. In this regard, we respectfully disagree with the implication in the Notice that investment income would be UBI under the general rule of section 512(a)(1) if not for the specific exclusions in section 512(b)(1), (2), (3), and (5).10 Because we believe that holding an investment portfolio is not the conduct of a “trade or business” as defined in section 513(c), we do not agree that these types of income are subject to the silo rule of section 512(a)(6). On this point we agree with the comments submitted by the ABA Section of Taxation on June 21, 2018.

The Notice indicates that the Service and Treasury believe that holding an investment portfolio is the conduct of a trade or business under section 513(c), but acknowledges that some possible interpretations of section 512(a)(6) flowing from that belief would cause undue administrative burdens. As discussed above, we disagree with the fundamental concept; however, we agree with the Notice on the administrative burden of an organization having to track separately its investment income from each of many debt-financed investments, for example. If permanent guidance will treat income described in section 512(b)(4), (13), and (17) as subject to section 512(a)(6), then we recommend that all such UBI be aggregated in a single silo for investment-related UBI. As we discuss in the next section, this should be the same silo already posited for investment-related income flowing through partnerships or other pass-through entities.

C. Notice Section 5 — Activities in the Nature of Investments

As we describe in Section B, above, we believe that passive investment income is not income from a trade or business, and therefore should not be subject to the silo requirement. If Treasury and the Service decide, as intimated in the Notice, to treat passive investment income as subject to the silo rule, then we recommend that all investment-related income should be aggregated into a single “investment UBI” silo. This silo should include income treated as UBI under section 512(b)(4), (13), and (17), as discussed above. It should also include any income allocated to the organization from a partnership or other pass-through entity that the organization does not control, which we discuss in this Section C. We discuss controlled partnerships in Section D, below.

Aggregating all passive investment-related UBI with income from non-controlled partnerships is reasonable given the purpose underlying the silo rule of preventing the perceived abuse of netting losses from one business against income from a separate business. Aggregating all passive investment-related UBI in a single silo would not allow investment income to be sheltered by losses from any active business, or vice versa, and will more closely align with the whole-portfolio approach that organizations use to analyze their investment activities under other regulatory regimes, including section 4944 (for private foundations) and the Uniform Prudent Management of Institutional Funds Act (for all charitable organizations, subject to state law).

Treating income from partnerships that the organization does not control as a type of investment-related income reflects the fact that many investments are held in the form of limited partnership interests. Even where the partnership (or lower-level entities, in the common case of multi-tier structures) is itself engaged in unrelated business activity, the exempt organization partner not only lacks control over that business activity, it may lack even the information to correctly silo income items from such activities. The Notice acknowledges this issue and states a goal of easing the compliance burden for organizations and the administrative burden on the Service. Thus, it is our recommendation that permanent guidance provide for a single “investment UBI” silo that will include UBI described in section 512(b)(4), (13), and (17), (whether earned directly by the organization or through pass-through organizations), as well as any UBI allocated through partnerships that the organization does not control. See our discussion in the next section regarding controlled partnerships.

D. Notice Section 6 — Interim and Transition Rules for Partnerships

Notice Section 6.01(2) provides that an organization may aggregate its UBTI from qualifying partnership interests if the partnership interests meet either the “De Minimis Test” or the “Control Test.” We agree with other commentators who explain why only the Control Test is necessary. That said, we offer recommendations as to how each test should be applied in case they are both adopted, and also comment on application of the proposed transitional rule.

1. De Minimis Test

In general, a partnership interest meets the de minimis test if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest. We have two recommendations for the application of this test.

First, we recommend that permanent guidance allow an exempt organization up to 90 days to reduce its interest in a partnership in order to satisfy the de minimis test if its percentage interest increased as a result of another partner's withdrawal or percentage reduction. This provision would closely align with section 4943, which provides a 90-day grace period for excess business holdings acquired other than by purchase.11 Establishing a similar 90-day grace period for purposes of the de minimis test is important so that exempt organizations have a reasonable opportunity to respond to changes outside their control.

Second, we recommend that permanent guidance be clear that an exempt organization is not required to combine its interests in a partnership with those of any disqualified person for purposes of calculating its de minimis percentage interest. This aligns with the de minimis rule of section 4943, which does not require inclusion of disqualified persons' holdings for purposes of calculating the organization's de minimis excess business holdings.12 We make this recommendation to ease the administrative burden on exempt organizations that may have a large number of disqualified persons, to make the test more administrable by the Service, and to bring conformity to de minimis tests with similar purposes.

2. Control Test

A partnership is a qualifying partnership interest under the control test if the exempt organization and related persons or entities (i) hold no more than 20% of the capital interest and (ii) based on all the facts and circumstances, do not have control or influence over the partnership. We have recommendations as to each prong of this test.

As to the first prong, we recommend 50% ownership as the threshold for control, consistent with section 512(b)(13) and many other areas of tax law. A partner that owns 20% of the capital interests in a partnership often docs not have “control” over that partnership in any real sense. In other contexts, as in section 512(b)(13), control is defined as ownership of more than 50% of the profits or capital interests in a partnership. Control in this context should be defined the same way. Conforming the control test with section 512(b)(13) will make application of the test more straightforward and predictable for both exempt organizations and the Service.

Consistent with our recommendation for the de minimis test, we also recommend that the interests of disqualified persons should not be aggregated with the exempt organization's partnership interests for purposes of the control test.

As to the second prong, we recommend that the Proposed Regulations specify that exempt organizations and the Service can look to the relevant partnership agreement to determine whether the exempt organization has control or influence over the partnership. For example, if the partnership agreement is clear that the exempt organization has no right to perform, or prevent the partnership from performing, any act that significantly affects the operations of the partnership, the control test should be satisfied.

3. Transitional Rule

Notice Section 6.04 acknowledges that it may be difficult for an exempt organization to modify a previously-acquired partnership interest to meet the de minimis or control tests. For that reason, the Service proposed a transitional rule that allows an exempt organization to treat a partnership interest acquired before August 21, 2018 as a single trade or business under section 512(a)(6) regardless of the actual number of trades or businesses conducted by the partnership.

The Notice does not state whether capital contributions made after August 21, 2018 will affect whether an organization can qualify for the transition rule. We recommend that the Proposed Regulations clarify that such contributions are not disqualifying, and that the transitional rule will apply to all partnership interests acquired before August 21, 2018 regardless of any subsequent capital contributions.

E. Notice Section 7 — Social Clubs, Etc.

The recommendations we make elsewhere in these Comments could apply equally to social clubs, VEBAs, and other organizations described in section 512(a)(3), despite the fact that UBI is defined more expansively for those organizations than for other exempt organizations. These organizations' non-exempt function income could be allocated among silos defined by the NAICS codes as described above, so our recommended safe harbor would not require alteration for these organizations. In addition, these organizations' investment income could be aggregated together in a single silo, consistent with our recommendation for other organizations. That said, Treasury should leave open the possibility of supplementing its regulations with revenue rulings or procedures to clarify and expand the guidance, in case unforeseen technical issues arise in applying the general rules to these specialized organizations.

F. Notice Section 9 — NOLs and UBTI

Permanent guidance should clarify how to read new section 512(a)(6) together with changes to section 172 for purposes of applying net operating losses (NOLs) in the UBTI calculation.

The Act modified section 172 in ways that specifically impact NOLs incurred after December 2017. Two of these changes are particularly important for calculating UBTI under the silo rule:

(1) deductions for post-2017 NOLs are capped at 80% of taxable income instead of 100%; and

(2) post-2017 NOLs will carry forward indefinitely instead of expiring in 20 years.

Reading these rules together with 512(a)(6), NOLs incurred within a silo after December 2017 can be carried forward indefinitely to offset up to 80% of income within that same silo.

In contrast, a separate section of the Act deals with the implications of the silo rule for historic NOLs—those arising in a taxable year beginning before January 1, 2018. Section 13702(b)(2) of the Act provides that historic NOLs can be used to offset total UBTI outside of any specific silo.

The different treatment of post-2017 NOLs and historic NOLs creates a wrinkle in the UBTI calculation for organizations that have both classes of NOLs because it is not clear which should be applied first for purposes of the silo rule. We recommend that final guidance resolve this uncertainty by clarifying that historic NOLs should be applied first. We make this recommendation because historic NOLs are subject to the 20-year expiration period. If post-2017 NOLs must be applied first, it is possible that historic NOLs could expire before an organization has the opportunity to use them. To avoid this result, organizations should be permitted to apply historic NOLs against the sum of all UBTI before applying post-2017 NOLs. Furthermore, final guidance should clarify that historic NOLs generated with respect to businesses not subject to section 512(a)(6) because the income is not derived from a trade or business, can also be used to offset total UBTI (that is, after applying the silo rule, if applicable to that organization).

Dated: December 3, 2018

FOOTNOTES

1References to a “section” or "§" are to a section of the Internal Revenue Code of 1986. as amended (the “Code”), unless otherwise indicated.

2References to “the Act” are to the Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, Pub. L. No. 115-97, 131 Stat. 2054.

3Code § 512(a)(6).

4See Code § 512(a)(6)(A).

5Sec 2017 Form 990-T. Block E, and Instructions, Business Activity Codes, page 30.

7In general, section 132 and regulations thereunder appear to be a helpful analogue for guidance, in that it, like section 512(a)(6), requires taxpayers to delineate between different trades or businesses.

8Commissioner v. Groetzinger, 480 U.S. 23, 29-30 (1987); Higgins v. Comm 'r. 312 U.S. 212. 218 (1941).

9Reg. § 1.513-1(b).

10The statement in the Notice that, absent those provisions, such income “would be included in the calculation of UBTI to the extent that such amounts are gross income derived by any organization from any unrelated trade or business" is correct but begs the question. If, consistent with Higgins and the plain language of section 512(a)(1), investing is not a trade or business, then the income types in question would be excluded under the general rule of section 512(a) even absent the specific exclusions except where they are generated from some other activity that does qualify as a trade or business, for example in the case of gains or losses arising from the sale of business equipment.

11See Reg. § 53.4943-9(a)(3).

12See Code § 4943(c)(2)(C).

END FOOTNOTES

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