Law Firm Seeks Clarification of UBTI Guidance

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

Re: Notice 2018-67

Ladies and Gentlemen:

We represent a group of private foundations described in Section 509(a) of the Internal Revenue Code of 1986, as amended (the “Code”), established by members of an extended family (collectively, the “Foundations”). The Foundations requested we provide the following comments regarding certain aspects of Notice 2018-67, 2018-36 I.R.B. 409, Request for Comments 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 (the “Notice”).

Introduction

Like many family offices and other groups of related tax-exempt organizations, the Foundations pool their investment funds in partnerships, frequently referred to as collective investment vehicles (“CIVs”), in order to obtain economies of scale, avoid duplicative fees, meet certain minimum investment thresholds for the funds in which the CIVs invest, and other valid business reasons that further the charitable purposes of the Foundations. Such CIVs are purely passive, flow-through entities that generate only investment income, including the CIVs' distributive share of income from partnerships in which the CIVs invest.

As summarized more fully below, Section 6 of the Notice provides an interim rule for the aggregation of unrelated business taxable income generated by one or more lower-tier partnerships and the aggregation of qualifying partnership interests so such interests are treated as a single trade or business for purposes of Section 512(a)(6) of the Code. If such interim rule is applied as described in the Notice and included in any proposed Treasury Regulations, the rule would potentially result in, without any apparent policy justification, a greater amount of unrelated business taxable income subject to taxation when earned by exempt organizations through CIVs versus unrelated business taxable income earned by exempt organizations holding direct interests in investment funds. Therefore, as described below, we respectfully suggest the interim rule be modified to take into account investment structures of exempt organizations like the Foundations that utilize CIVs in determining whether a partnership interest is a qualifying partnership interest. An analysis of relevant parts of the Notice, applicable law, the interim rule and its impact and the suggested modification to the interim rule follows.

The Notice and the Interim Rule

On August 21, 2018, the Internal Revenue Service released the Notice. The Notice provides, among other things, interim and transition rules for organizations and trusts described in Sections 511(a)(2) and 511(b)(2), respectively, of the Code investing in partnerships or other entities treated as partnerships for federal income tax purposes (hereinafter referred to as “partnerships”). Such organizations and trusts described in Sections 511(a)(2) and 511(b)(2) of the Code are collectively referred to herein as “exempt organizations.”

More specifically, Section 6.01(2) of the Notice provides an interim rule (the “Interim Rule”) to determine whether an exempt organization recognizing unrelated business taxable income from an interest in a partnership was generated by one or more trades or businesses. The Interim Rule provides that, pending publication of proposed Treasury Regulations, an exempt organization may aggregate its unrelated business taxable income (“UBTI”) for purposes of Section 512(a)(6) of the Code allocable from a single partnership with multiple trades or businesses conducted by other partnerships in which such partnership holds a partnership interest, as long as the exempt organization's interest in such partnership meets either the de minimis test set forth in Section 6.02 of the Notice (the “De Minimis Test”) or the control test set forth in Section 6.03 of the Notice (the “Control Test”) (a “Qualifying Partnership Interest”). Additionally, under the Interim Rule, an exempt organization may aggregate all Qualifying Partnership Interests and treat the aggregate group as comprising a single trade or business for purposes of Section 512(a)(6)(A).

Section 12 of the Notice requests comments regarding, among other things, the treatment of income derived from activities in the nature of investment through partnerships. As noted, we provide the following comments in response to such request on behalf of the Foundations because the Interim Rule, as currently drafted, may result in unintended consequences, including potential taxation of the income of exempt organizations from CIVs as UBTI.

Applicable Law

Section 511(a)(1) of the Code imposes a tax on the UBTI of exempt organizations, which are otherwise generally exempt from federal income taxation, subject to limited exceptions. Section 512(a) of the Code defines UBTI as the gross income derived by any exempt organization from an unrelated trade or business regularly carried on by it, less the deductions allowed under Chapter 1 of the Code directly connected with the carrying on of such trade or business, all as computed with the modifications set forth in Section 512(b) of the Code.

Section 513(a) of the Code defines an “unrelated trade or business” as any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by an exempt organization of its charitable, educational, or other purpose or function constituting the basis for its exemption from federal income tax. Section 512(c) of the Code provides that, if a trade or business regularly carried on by a partnership in which an exempt organization is a partner is an unrelated trade or business with respect to such exempt organization, the exempt organization must include in its UBTI its distributive share of the partnership's gross income and deductions directly connected with such gross income.

Enacted on December 22, 2017, Public Law 115-97 (131 Stat. 2054 (2017)) added new Section 512(a)(6) to the Code. Prior to the enactment of Section 512(a)(6) of the Code, an exempt organization deriving UBTI from two or more unrelated trades or businesses was permitted to deduct the aggregate deductions from all such trades or businesses from the aggregate income from all such trades or businesses to calculate such exempt organization's UBTI. Effective for taxable years beginning after December 31, 2017 (but excluding net operating losses arising prior to January 1, 2018), however, Section 512(a)(6) of the Code now requires exempt organizations with more than one unrelated trade or business to separately compute UBTI with respect to each such trade or business.

The foregoing change in law concerned many exempt organizations about both potential increases in tax arising from UBTI and the significant administrative burden of separately computing UBTI for each unrelated trade or business. Such concern was particularly acute in the context of UBTI allocated from partnerships in which exempt organizations are partners under Section 512(c) of the Code. We understand the Notice was intended in part to address some of the concerns of exempt organizations related to Section 512(a)(6) of the Code by introducing the Interim Rule.

Impact of the Interim Rule

As noted above, an exempt organization may rely on the Interim Rule only if its interest in a partnership meets the De Minimis Test or the Control Test. Exempt organizations whose interests in one or more partnerships satisfies either test may treat all such Qualifying Partnership Interests as one unrelated trade or business for purposes of Section 512(a)(6) of the Code, and therefore, aggregate all UBTI allocable to the exempt organization in respect of such Qualifying Partnership Interests.

The De Minimis Test and the Control Test have specific requirements. An exempt organization's interest in a partnership satisfies the De Minimis Test if the exempt organization holds directly no more than two percent (2%) of each of the profits and capital interests in the partnership, subject to aggregation rules for related parties. An exempt organization's interest in a partnership satisfies the Control Test if the exempt organization (i) directly holds no more than twenty percent (20%) of the capital interests in the partnership and (ii) does not have control or influence over the partnership, subject to aggregation rules for related parties.

As noted, like many family offices and other groups of related exempt organizations, the Foundations pool their investment funds in partnerships, including CIVs. The Foundations make such investments in order to obtain economies of scale, avoid duplicative fees, meet certain minimum investment thresholds for the funds in which the CIVs invest, and other valid business reasons that further the charitable purposes of the Foundations. As also noted above, CIVs are purely passive, flow-through entities that generate only investment income, including the CIV's distributive share of income from partnerships in which the CIVs invest.

As the Interim Rule is currently set out in the Notice, using CIVs to pool the investments of exempt organizations, including the Foundations, would exclude such investments from the ambit of the interim Rule. This is the case because an exempt organization's interest in a CIV would in most cases fail to satisfy either the De Minimis Test or the Control Test. For example, if three exempt organizations each contributed $X to a CIV in exchange for a thirty-three percent (33%) interest in the profits and capital of the CIV, such partnership interests would fail both the De Minimis Test and Control Test. Specifically, the De Minimis Test would not be satisfied because each exempt organization would hold directly more than two percent (2%) of each of the profits and capital interests in the CIV and the Control Test would not be satisfied because each exempt organization would have a greater than twenty percent (20%) interest in the CIV's capital, without regard to applicable aggregation rules for related parties.

The result of the foregoing application of the Interim Rule is that such exempt organizations could not (1) aggregate UBTI generated by potentially hundreds of lower-tier investments held by the CIV and (2) aggregate all of the Qualifying Partnership Interests in CIVs or other directly held funds in which it invests as a single trade or business for purposes of Section 512(a)(6) of the Code. The Interim Rule would impose this result even if the income allocable from such partnerships in which the CIV invests could be treated as income from a single unrelated trade or business if the exempt organizations invested in such partnerships directly rather than through a CIV.

There does not appear to be any policy justification for the foregoing disparate treatment between exempt organizations investing directly in partnerships and those like the Foundations that pool funds for investment in passive CIVs. Yet, under the Interim Rule, the latter could generate more UBTI and thus more tax liability for exempt organizations that use CIVs and are thereby excluded from the Interim Rule.

Suggested Modification to the Interim Rule of the Notice

To address these concerns, we propose that the Interim Rule be modified and any proposed Treasury Regulations on the issue be drafted to incorporate the common situation of exempt organizations like the Foundations utilizing investment vehicles like CIVs. Specifically, we suggest the Interim Rule be modified to take into account partnerships, including CIVs, that (i) are owned exclusively by exempt organizations and (ii) the sole source of income for which is in the nature of passive income from investments, including the distributive share of income from partnerships in which they invest, by disregarding such partnerships, including CIVs, for purposes of applying the De Minimis Test and Control Test, or corresponding concepts in future proposed Treasury Regulations.

An example illustrates our proposed modification of the Interim Rule. Under our proposed modification, if three exempt organizations each contributed $X to a CIV in exchange for a thirty-three percent (33%) interest in the profits and capital of the CIV, we propose that the De Minimis Test and Control Test (or corresponding concepts in future proposed Treasury Regulations) be applied by disregarding or “looking through” the CIV and treating such exempt organizations as if they owned directly thirty-three percent (33%) of the CIV's interest in the profits and capital of any partnerships in which the CIV invests. Thus, if the CIV holds a ten percent (10%) interest in a private equity fund, each exempt organization would be treated as directly owning a three and one-third percent (3.33%) interest in such private equity fund for purposes of applying the De Minimis Test and Control Test.

The foregoing suggested modification of the Interim Rule would eliminate the arbitrary differences between exempt organizations investing directly in partnerships and exempt organizations like the Foundations investing through CIVs that result from applying the Interim Rule as currently drafted.

If you have any questions regarding these comments, please direct them to the undersigned at (216) 861-7350 or wculbertson@bakerlaw.com.

Thank you for your consideration of the foregoing.

Very truly yours,

William J. Culbertson
Baker&Hostetler, LLP
Cleveland, OH