Individual Suggests Practical Approach to UBTI Calculation

June 29, 2020

CC:PA:LPD:PR (REG-106864-18)
Room 520
Internal Revenue Service
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Re: Unrelated Business Taxable Income Separately Computed for Each Trade or Business

Dear Mr. Carter,

This letter comments on the proposed regulations in REG-106864-18, Unrelated Business Taxable Income Separately Computed for Each Trade or Business, 85 Fed. Reg. 23172 (April 24, 2020). The deadline for comments was June 23, 2020. However, a review of the final submitted comments found that no commentator appears to have objected to the appropriateness of using two-digit NAICS sector codes to group unrelated trades or businesses, which would allow for example a non-profit organization to offset its profits from an oil well with losses from a coal mine (both under NAICS sector code 21 for mining, quarrying, and oil and gas extraction businesses) or to combine taxis and natural gas pipelines (under NAICS sector code 48 for transportation businesses). Accordingly, the purpose of this letter is to belatedly point out that the proposed regulations' use of two-digit NAICS sector codes is improper, is contrary to the statute and Congressional intent, and provides an unwarranted tax subsidy for tax-exempt organizations to earn untaxed income from a profit-seeking activity that is not substantially related to their tax-exempt purposes.

Public Law No. 115-97, also known as the Tax Cuts and Jobs Act of 2017 (TCJA), enacted two tax provisions that apply 'siloing' rules to a taxpayer's separate trades or businesses. One provision is section 512(a)(6), which generally provides that a tax-exempt organization's unrelated business taxable income, including for purposes of determining any net operating loss (NOL) deduction, shall be computed separately with respect to each unrelated trade or business in 2018 and later. The second provision is section 199A(b)(2), which generally provides that a non-corporate taxpayer's 20% pass-through business income deduction in 2018 through 2025 is subject to separate limitations based on the W-2 wages and unadjusted basis of depreciable property for each trade or business.

Both provisions use the term “trade or business,” which under standard canons of statutory construction should be construed to have the same meaning in the same statute enacted by the same Congress.¹ Both provisions further Congress's intent that a taxpayer should not be permitted to blend certain tax items or tax attributes, whether they are NOLs, W-2 wages, or unadjusted basis, across different trades or businesses in order to reduce its federal income tax liabilities.

The issue of what constitutes a separate “trade or business” under the TCJA was extensively studied and resolved in 2018 and early 2019, when regulations were proposed and finalized under section 199A. The section 199A final regulations in T.D. 9847, 84 Fed. Reg. 2952 (Feb. 8, 2019) declined to allow any broad grouping. Instead, the section 199A final regulations' preamble explained at 84 Fed. Reg. 2954-2956:

The proposed regulations define trade or business by reference to section 162. Section 162(a) permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business. Multiple commenters agreed that section 162 is the most appropriate standard for what constitutes a trade or business for purposes of section 199A, but noted that there are significant uncertainties in the meaning of trade or business under section 162. However, because many taxpayers who will now benefit from the section 199A deduction are already familiar with the trade or business standard under section 162, using the section 162 standard appears to be the most practical for taxpayers and the IRS. Therefore, after considering all relevant comments, the final regulations retain and slightly reword the proposed regulation's definition of trade or business. Specifically, for purposes of section 199A and the regulations thereunder, § 1.199A-1(b)(14) defines trade or business as a trade or business under section 162 (section 162 trade or business) other than the trade or business of performing services as an employee. . . .

Several commenters suggested that there should be safe harbors or factors to determine how to delineate separate section 162 trades or businesses within an entity and when an entity's combined activities should be considered a single section 162 trade or business. Some of the factors suggested include whether the activities: Have separate books and records, facilities, locations, employees, and bank accounts; operate separate types of businesses or activities; are held out as separate to the public; and are housed in separate legal entities. One commenter suggested adopting the separate trade or business rules provided in regulations under sections 446 and 469.

The Treasury Department and the IRS decline to adopt these recommendations because specific guidance under section 162 is beyond the scope of these final regulations and, as described in part II.A.3.a. of this Summary of Comments and Explanation of Revisions, guidance under section 469 is inapplicable. Further, § 1.446-1(d) does not provide guidance on when trades or businesses will be considered separate and distinct. Instead, it provides that a taxpayer can use different methods of accounting for separate and distinct trades or businesses and specifies two circumstances in which trades or businesses will not be considered separate and distinct. Section 1.446-1(d)(2) provides that no trade or business will be considered separate and distinct unless a complete and separable set of books and records is kept for such trade or business.

The Treasury Department and the IRS acknowledge that an entity can conduct more than one section 162 trade or business. This position is inherent in the reporting requirements detailed in § 1.199A-6, which require an entity to separately report QBI, W-2 wages, UBIA of qualified property, and SSTB information for each trade or business engaged in by the entity. Whether a single entity has multiple trades or businesses is a factual determination. However, court decisions that help define the meaning of “trade or business” provide taxpayers guidance in determining whether more than one trades or businesses exist. As discussed in part II.A.3.a. of this Summary of Comments and Explanation of Revisions, generally under section 162, to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer's primary purpose for engaging in the activity must be for income or profit. Groetzinger, at 35.

The section 199A final regulations contain a limited aggregation rule but do not permit a non-corporate taxpayer to use two-digit NAICS sector codes to group its trades or businesses subject to section 199A. A residential real property rental business cannot be aggregated with a commercial real property rental business,² although both would be in NAICS sector code 53 for all real estate, rental and leasing businesses. Even two or more otherwise identical trades or businesses cannot be aggregated if their ownership differs by more than 50% or if they do not share certain functions, such as three grocery stores that are operated independently.³

In contrast, the section 512(a)(6) proposed regulations provide that all businesses under a single two-digit NAICS sector code are generally considered a single trade or business. A tax-exempt organization would have at most around twenty separate trades or business that are subject to section 512(a)(6). Commentator have pointed out that (i) a ski resort can be combined with a music concert venue, under NAICS sector code 71 for arts, entertainment, and recreation businesses, and (ii) a pharmacy can be combined with a gift shop, under NAICS sector code 44 for certain retail trade businesses.⁴

Similarly, a tobacco store and a propane vendor are both under NAICS sector code 45 for certain other retail trade businesses, a nail salon and an auto shop are both under NAICS sector code 81 for other services, and a veterinarian and an interior design business are both under NAICS sector code 54 for professional, scientific, and technical services. The use of two-digit NAICS sector codes is particularly overbroad when businesses with even the same six-digit NAICS code can be considered separate businesses for other Code provisions, such as the three separate grocery stores under section 199A that would all use NAICS code 445110.

If Treasury and the IRS have revised their views as to the Congressional intent of what is a separate “trade or business” for purposes of the TCJA's tax provisions, the same trade or business definition should consistently be incorporated into the section 199A regulations. In other words, a non-corporate taxpayer should be able to compute its W-2 wages and unadjusted basis in depreciable property on an aggregate basis with respect to all of its businesses that use the same two-digit NAICS code, such as NAICS sector code 42 for wholesale trade businesses, NAICS sector code 55 for management businesses, and NAICS sector code 23 for construction businesses. This outcome would allow small businesses and other non-corporate taxpayers to benefit from same administrative simplicity and reduced compliance rationales that justify the use of two-digit NAICS sector codes in the tax-exempt organization context.

It should be noted that the siloing effect of section 512(a)(6) is typically a temporary timing effect as to whether a tax-exempt organization's NOL deduction from an unrelated trade or business can be used currently (against taxable income from other unrelated trades or businesses) or only in the future against taxable income from the same unrelated trade or business. Section 172(a) provides that NOLs generated in 2018 and later, which are the years subject to section 512(a)(6), can be carried forward indefinitely. The unrelated trade or business should be reasonably expected to generate taxable income in the future, as otherwise the unrelated trade or business is not being operated with a profit motive and all of its losses would be fully disallowed under section 162 or section 183.⁵ In contrast, the siloing effect of section 199A is typically a permanent detriment to the taxpayer; a non-corporate taxpayer who does not have enough W-2 wages or unadjusted basis in a taxable year would permanently lose some or all of its section 199A deduction in such taxable year, even if the taxpayer has excess W-2 wages or unadjusted basis in future taxable years. Given the harsh consequences under section 199A and the Congressional intent to benefit pass-through businesses using that provision, it seems unreasonable for section 199A to apply a stricter aggregation rule than section 512(a)(6).

An alternative, practical, and similarly consistent approach would be to conform the section 512(a)(6) provisions to the section 199A final regulations and to use general trade or business concepts under section 162 with a limited aggregation rule. To quote the preamble to the section 199A final regulations, given that many taxpayers “are already familiar with the trade or business standard under section 162, using the section 162 standard appears to be the most practical for taxpayers and the IRS.”⁶ Furthermore, “whether a single entity has multiple trades or businesses is a factual determination. However, court decisions that help define the meaning of 'trade or business' provide taxpayers guidance in determining whether more than one trades or businesses exist.”⁷

The final Treas. Reg. § 1.512(a)-6(b) should provide that a tax-exempt organization must apply general section 162 principles and case law in determining its separate trades or businesses.⁸ In a manner analogous to Treas. Reg. § 1.199A-4(b), the tax-exempt organization can aggregate its unrelated trades or businesses if it can demonstrate that:

Similar aggregation rules should apply to a tax-exempt organization's “investment” activities that rise to the level of trade or businesses under section 162, instead of grouping them all in an “investment silo” as proposed under Prop. Treas. Reg. § 1.512(a)-6(c)(1). For example, a tax-exempt organization's debt-financed residential rental property business would be separate from its debt-financed commercial rental property business, just as they would be for a non-corporate taxpayer under section 199A.

Most taxpayers and tax advisors have become very familiar with the requirements of section 199A over the past two years, and the knowledge and expertise developed in the section 199A context can be quickly and easily applied to the section 512(a)(6) area. It does not seem proper that tax-exempt organizations are allowed to apply broad grouping rules in determining their separate unrelated trades or businesses based on entire economic sectors, while their taxable counterparts are subject to narrower rules and stricter aggregation requirements.

Some might argue that the section 199A principles would impose unreasonable compliance burdens on small tax-exempt organizations. The section 199A final regulations apply to large and many small businesses,⁹ and the same principles can similarly apply to smaller non-profit organizations, who are not likely to have even one unrelated trade or business in the first place, let alone multiple unrelated trades or businesses. The beneficiaries of the ability to use two-digit NAICS sector codes are likely large non-profit organizations with substantial endowments and the ability to offset their taxable income from unrelated trades or businesses with losses from other unrelated trades or businesses in the same general economic sector, such as gun manufacturers and furniture manufacturers in NAICS sector code 33 (manufacturing), trailer parks and exotic dance clubs in NAICS sector code 71 (accommodation and food services), or timber logging and cannabis farming in NAICS sector code 11 (farming).

The TCJA's Congress showed a preference in favoring small businesses (and other non-corporate taxpayers) and targeting tax-exempt organizations' use of tax benefits that are unrelated to their tax-exempt purposes, yet the 512(a)(6) proposed regulations aim to reverse this Congressional intent. Specifically, section 512(a)(6) is just one of many TCJA provisions aimed at tax-exempt organizations, sometimes more severely than their taxable counterparts:

The section 512(a)(6) final regulations should be consistent with Congress's intent and the TCJA's statutory provisions to prevent tax-exempt organizations from obtaining tax advantages that are inconsistent with their tax-exempt purposes, which includes using losses from a yacht dealership against its income from a liquor store (both under NAICS sector code 44).