Comments Raise Questions With Investment Rules Under UBTI Guidance

UBTI and Notice 2018-67

Interaction of section 512(b)(6) and section 501(c)

1) Investment activity.

Section 5.02 of Notice 2018-67 provides that Treasury and the IRS intend to treat “certain activities in the nature of an investment ('investment activities') of an exempt organization as one trade or business for purposes of section 512(a)(6)(A) in order to permit exempt organizations to aggregate gross income and directly connected deductions from such 'investment activities.'”

Currently, certain investment income, such as interest, dividends, royalties, and rents, is excluded from the UBTI calculation entirely. See sections 512(b)(1), (2), and (3).

2) Qualifying partnership interest.

Investment income may be aggregated for purposes of section 512(a)(6)(A) if it is from a qualifying partnership interest. A qualifying partnership interest must meet either the de minimis test or the control test.

Under the de minimis test, a partnership interest is a qualifying interest if the exempt organization holds no more than a 2 percent profits interest and a 2 percent capital interest.

Under the control test, a partnership interest is a qualifying interest if the exempt organization holds no more than a 20 percent profits interest and does not have control or influence over the partnership.

3) Interaction of section 512(a)(6) with certain section 501(c) organizations.

Section 7 of Notice 2018-67 notes that social clubs, VEBAs, and SUBs have special rules that apply for the calculation of UBTI (specifically, these types of entities calculate non-exempt function income), and requests comments on how section 512(a)(6) should apply in these cases.

There are several types of 501(c) organizations that have specific limitations around the type of income that can be received that differ from the rules that apply to 501(c)(3) and other organizations generally. Failure to meet these standards may result in the loss of exempt status.

These entities are defined in sections: 501(c)(11), (12), (13), (14), (21), (22), and (25).

For example, under section 501(c)(11) a teacher's retirement fund association may only have income that consists of “amounts received from public taxation, amounts received from assessments on the teaching salaries of members, and income in respect of investments.” A section 501(c)(12) organization, such as a mutual or cooperative telephone company, must have 85 percent of more of its income consist of “amounts collected from members for the sole purpose of meeting losses and expenses.” Within section 501(c)(12) special rules apply that allows certain income to be ignored. Finally, section 501(c)(13) provides for exempt status for a corporation engaged in burial and cremation if it is “not permitted by its charter to engage in any business not necessarily incident to that purpose . . .”

How do these existing limitations interact with the investment rules under Notice 2018-67?

Possible answers:

A) Qualifying partnership income should not be considered an unrelated trade or business and excluded from the separate trade or business rule under section 512(a)(6) because it is investment income given the structure of the investment, even if some of the income may be ordinary. Thus, the use of “trade or business” in the Notice is organizational and does not reflect a decision to now treat investment activities and income as an unrelated trade or business.

B) Qualifying partnership income is unrelated trade or business income for purposes of creating a separate trade or business bucket under section 512(a)(6).

Questions Raised:

Would a telephone coop under section 512(c)(12), for example, not qualify for the qualifying partnership exception given the 85 percent test and other special requirements, so that such an entity would need to look through all partnership interests to determine the exact income? Would the exception apply only to the extent the investment in the qualifying partnership interest was related to the providing telephone services to members (see PLRs)? Would the exception only apply to the extent that the income is investment income?

Would a cemetery company under section 512(c)(13), for example, be able to hold a qualifying partnership interest and treat all income from that interest as investment income, even if some of the income is ordinary business income? Does the qualifying partnership interest exception still require that investment income and ordinary income be separated (or income excluded from UBTI and income included in UBTI), and that income is aggregated and netted? If the income is separated, can investment income from a qualifying partnership interest be aggregated and netted with all other investment income, but not investment income from non-qualifying partnership interests?