Notre Dame Urges Increase in Threshold in Proposed UBTI Regs

June 22, 2020

The Honorable David Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220

The Honorable Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Ms. Stephanie N. Robbins
Office of Associate Chief Counsel (TEGE)
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Mr. Jonathan A. Carter
Office of Associate Chief Counsel (TEGE)
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Re: Comments to Proposed Regulations Issued under § 512(a)(6) (REG-106864-18)

Dear Sirs and Madam:

I. Introduction

The University of Notre Dame du Lac respectfully submits these comments with respect to the proposed regulations issued on April 24, 2020 (REG-106864-18) (the "Proposed Regulations") regarding the application of Section 512(c)(6) of the Code to unrelated business taxable income ("UBTI"). Our comments focus on the proposed rules regarding investments in partnerships.

We are a large private university that is tax-exempt under Section 501(c)(3) of the Code. Like many other exempt organizations, including pension funds, private foundations and other universities, we maintain an investment portfolio to fund our long-term operational needs. A portion of these investments is allocated to private investment funds, which are typically structured as limited partnerships or other entities that are classified as partnerships for U.S. federal income tax purposes ("Investment Funds"). These investments consist of interests in many different Investment Funds in order to diversify holdings and to obtain exposure to various categories of private investments and investment strategies. At any time, we hold interests in hundreds of separate Investment Funds.

Investment Funds may generate UBTI as a result of investing in businesses that are themselves structured as pass-through entities ("Lower Tier Partnerships"), as a result of borrowing by the Investment Funds or the Lower Tier Partnerships, or from certain fees or other income earned by the Investment Funds in connection with their investment activities.

Exempt organizations invest in Investment Funds as passive investors and do not significantly participate in the management of the Investment Funds, their investment decisions or their other operations. Investment decisions are made by each Investment Fund's general partner, and in some cases by an investment manager that is typically affiliated with the general partner. Exempt organizations generally do not have any interest in the general partner or the investment manager. In some cases exempt organizations may be part of an advisory committee made up of limited partners, which has limited authority to approve certain transactions that are outside of the scope of an Investment Fund's normal investment parameters or that involve a conflict of interest for the Investment Fund's general partner.

II. Section 512(a)(6) and the Proposed Regulations

For tax years beginning after December 31, 2017, Section 512(a)(6) of the Code requires exempt organizations, such as us, to compute UBTI separately with respect to each unrelated trade or business. Due to the significant number of Investment Funds in which we hold interests, and the number of Lower Tier Partnerships in which the Investment Funds hold interests, it would be administratively burdensome for us to determine our UBTI separately with respect to each Investment Fund and/or each Lower Tier Partnership. In most cases, we do not currently receive or have access to the information that would be necessary for us to make such a determination. The Treasury Department and the IRS have acknowledged the potential difficulty we, and similarly situated investors, would face in obtaining the necessary information to report UBTI for each Investment Fund/Lower Tier Partnership.¹

In Notice 2018-67 (2018-36 IRB 409), the Treasury Department and the IRS indicated their intention to propose regulations to permit certain activities in the nature of an investment to be treated as one trade or business, and to treat investments in partnerships as investment activities where the exempt organization does not significantly participate in any partnership trade or business. Accordingly, the Proposed Regulations permit an exempt organization's investment activities to be aggregated as a single unrelated trade or business. The Proposed Regulations generally limit investment activities to investments in "qualifying partnership interests," "qualifying S corporation interests" and debt-financed property. Our comments focus on the circumstances in which an interest in an Investment Fund will constitute a "qualifying partnership interest."

The Proposed Regulations define a "qualifying partnership interest" (a "QPI") as a direct interest in a partnership that meets the requirements of either a "de minimis test" or a "control test." The de minimis test is met if the exempt organization holds no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership. The control test requires an exempt organization to hold no more than 20% of the capital interest in the partnership and not to control the partnership. For purposes of the control test (but not the de minimis test), an exempt organization's percentage interest in a partnership includes interests held by a "supporting organization" (within the meaning of Section 509(a)(3) of the Code) or a "controlled entity" (within the meaning of Section 512(b)(13)(D) of the Code). Indirectly-held interests in lower tier partnerships may also be QPIs if the indirect interests are held through an upper tier partnership that the exempt organization does not control (within the meaning of the control test) and the indirectly-held partnership interests meet the requirements of the de minimis test.

The Proposed Regulations make several improvements to the de minimis test and the control test as originally set forth in Notice 2018-67. In particular, Notice 2018-67 required an exempt organization to aggregate its interest in a partnership with interests held by supporting organizations, controlled entities and "disqualified persons" (within the meaning of Section 4958(0 of the Code) for purposes of both the de minimis test and the control test. The Proposed Regulations do not require such aggregation for purposes of the de miminis test, and do not require aggregation of interests held by disqualified persons for purposes of the control test. We appreciate these changes, which will make the de minimis test and the control test significantly easier to apply. These improvements should be retained in the final regulations.

II. Comment: The Ownership Threshold For Purposes of Satisfying the Control Test Should be Increased to 50% of the Capital Interest in the Partnership

We agree with the Treasury Department's and the IRS's statement in Notice 2018-67 and in section 2.c of the preamble to the Proposed Regulations that partnership interests should be treated as investment activities only if the exempt organization does not significantly participate in any partnership trade or business. However, we believe the ownership threshold for purposes of satisfying the control test should be increased to a 50% capital interest. We understand that the Treasury Department and the IRS received numerous comments to Notice 2018-67 that suggested increasing the 20% ownership threshold to 50%, but the Proposed Regulations retain the 20% ownership threshold. The preamble to the Proposed Regulations does not explain why the recommendations to increase the ownership threshold to 50% were not adopted, so we are providing a more detailed explanation of why we believe the ownership threshold should be increased to 50%.

As a practical matter, exempt organizations are passive investors in Investment Funds and do not significantly participate in any trade or business of the Investment Funds or their Lower Tier Partnerships. However, an exempt organization may hold a greater than 20% capital interest in one or more Investment Funds. The requirement that an exempt organization hold no more than a 20% capital interest in a partnership is an arbitrary limitation that does not correspond to the likelihood that the exempt organization significantly participates in the partnership's trade or business. An exempt organization typically has no more active involvement in the management of an Investment Fund in which it holds a greater than 20% capital interest as compared to an Investment Fund in which it holds less than a 20% capital interest.

Investment Funds are generally structured as limited partnerships in which investors, including exempt organizations, are limited partners. The nature of a limited partnership interest (as opposed to a general partnership interest) limits the limited partner from significantly participating in the investment activities or operations of the partnership regardless of the size of the limited partner's capital interest. The Proposed Regulations recognize this distinction between the nature of a general partner interest and a limited partner interest. Under the Proposed Regulations, if an exempt organization is a general partner in a partnership its interest in that partnership is not a QPI regardless of the exempt organization's percentage interest. Given that a partnership interest can never be a QPI if the exempt organization is a general partner of the partnership, allowing an exempt organization to own up to 50% of a partnership in which the exempt organization's interest is solely that of a limited partner does not increase the likelihood that the exempt organization will significantly participate in the partnership's trade or business.

The general partner of an Investment Fund, and in some cases an investment manager, is responsible for making all investment decisions and managing the Investment Fund, for which it is paid management fees. A limited partner's voting rights are limited to extraordinary actions such as approving significant amendments to the partnership agreement, removing the general partner, and terminating or extending the term of the Investment Fund. These voting rights are similar to the voting rights that an investor in corporate stock would have. In some cases limited partners of Investment Funds may serve on an advisory committee whose role is generally limited to approving certain conflict of interest transactions involving the general partner, and approving actions that fall outside of the scope of investment guidelines set out in the partnership agreement. These limited approval rights do not constitute significant participation in the operations or investments of the Investment Funds. An exempt organization's interest as a limited partner in an Investment Fund is truly that of a passive investor, regardless of the size of that interest.

While it is inherent in the legal nature of a limited partnership (as opposed to a general partnership) that limited partners do not participate in day-to-day management of the partnership and it is therefore arguable that no limited partner can ever control a limited partnership, we understand the Treasury Department's and the IRS's preference for a bright line evaluation and resulting imposition of a control test that includes a maximum percentage interest. However, we believe the 20% ownership threshold is too low for purposes of a test for control. The preamble to the Proposed Regulations states that the ownership threshold is intended to be a proxy to identify partnership interests in which the exempt organization does not significantly participate in any trade or business. It is not apparent why a 20% ownership threshold is a better indicator of participation in a partnership trade or business than a 50% ownership threshold. This is particularly true when taking into account the fact that a partnership interest cannot be a QPI under the Proposed Regulations if the exempt organization is a general partner of that partnership, and the requirement that the exempt organization does not control the partnership based on the facts and circumstances test contained in the Proposed Regulations.

In other areas of the Code, control of a partnership is more often defined as owning more than 50% of the profits or capital interests in the partnership. For example, for purposes of imputing UBTI from a "controlled entity" under Section 512(b)(13) of the Code, a partnership is considered a "controlled entity" if the exempt organization owns more than 50% of the profits interests or capital interests of the partnership.² Similarly, the rules on excess benefit transactions under Section 4958 of the Code treat a partnership as being controlled by an exempt organization if the exempt organization owns more than 50% of the profits interests or capital interests in the partnership.³ Several other sections of the Code similarly apply a 50% ownership threshold when testing for control of a partnership.⁴ The preamble to the Proposed Regulations acknowledges the 50% control test in Section 512(b)(13) of the Code, but provides no explanation for why a 20% ownership threshold should apply for purposes of the control test other than to refer to regulations under Section 731(c)(3)(C)(i) of the Code as an example of a 20% ownership threshold. Unlike the 50% control tests cited above, the regulations under Section 731(c)(3)(C)(i) of the Code do not purport to be a test of partnership control. Rather, the regulations under Section 731(c)(3)(C)(i) of the Code seek to identify situations in which the trade or business activities of a lower tier partnership should be attributed to an upper tier partnership for purposes of determining whether the upper tier partnership is engaged in a trade or business. That question does not arise in the context of UBTI because, under Section 512(c)(1) of the Code, an exempt organization's share of any UBTI generated by a partnership is attributed to the exempt organization regardless of the size of the exempt organization's ownership interest in the partnership. The relevant question under Section 512(a)(6) of the Code then is not whether a partnership's trade or business income should be attributed to an exempt organization partner (it will be), but rather whether the exempt organization's level of participation in the partnership's trade or business activities makes the UBTI from that partnership sufficiently different from the exempt organization's UBTI from its other investment activities such that it should be treated as derived from a separate unrelated trade or business. That question is best answered by determining whether the exempt organization's ownership of the partnership is sufficiently large that it is likely to provide the exempt organization significant control over the partnership, and thus is more analogous to the control tests in Section 512(b)(13) of the Code and the other Code sections noted above that apply a 50% ownership threshold.

The application of a 50% ownership threshold for other control tests in the Code reflects the fact that a minority partner (that is, a partner owning 50% or less of a partnership) is generally not able, on its own, to exert control over the operations and activities of the partnership. This is especially true when the partner's interest is solely that of a limited partner. The vast majority of Investment Funds are formed as Delaware limited partnerships. Under §17-303 of the Delaware Revised Uniform Limited Partnership Act, a limited partner in a Delaware limited partnership has limited liability only if the limited partner does not participate in the control of the partnership's business.⁵ But regardless of the form or jurisdiction of an Investment Fund, the management control over the Investment Fund is generally reserved to the sponsor and its affiliates. Investors, including exempt organizations, are not given the ability to manage or control the day-to-day operations of the Investment Fund or to participate in the trade or business of the Investment Fund or any Lower Tier Partnerships.

Although the control tests found in other parts of the Code are often based solely on percentage ownership, the control test contained in the Proposed Regulations contains two additional requirements that must be satisfied for a partnership interest to be a QPI. First, the exempt organization must not be a general partner of the partnership. Second, the exempt organization cannot control the partnership as determined based on a separate facts and circumstances test. The Proposed Regulations provide that an exempt organization controls a partnership if (i) the exempt organization may require the partnership to perform, or prevent the partnership from performing, any act that significantly affects the operations of the partnership, (ii) the exempt organization has the power to appoint or remove any of the partnership's officers or employees or a majority of directors, or (iii) the exempt organization's officers, directors, trustees, or employees have rights to participate in the management of the partnership or to conduct the partnership's business. These additional requirements ensure that an exempt organization will not significantly participate in any partnership trade or business even if it owns up to a 50% capital interest in the partnership, and thus provide additional justification for raising the ownership threshold to 50%.

Allowing an exempt organization to own up to 50% of the capital interest of a partnership for purposes of the control test will reduce the burden that would be imposed on exempt organizations and the IRS if an exempt organization were required to treat each partnership in which it owns a greater than 20% capital interest as a separate trade or business irrespective of whether the exempt organization has any right to significantly participate in the partnership's trade or business. As previously noted, an exempt organization generally will not hold a general partner interest in an Investment Fund and will not control an Investment Fund based on the facts and circumstances test, so in most cases the treatment of an interest in an Investment Fund as a QPI will hinge solely on satisfying the ownership threshold. Increasing this threshold to 50% would meet the stated goal of the Treasury Department and the IRS of reducing administrative burden both on exempt organizations and the IRS, while still ensuring that only interests in partnerships in which the exempt organization does not significantly participate in any partnership trade or business are treated as QPIs.

The preamble to the Proposed Regulations notes that an exempt organization's interest in a partnership may change during a year due to actions taken by other partners, and that the exempt organization may not be aware of the change until it receives its Schedule K-1 after the end of the partnership's taxable year. The Treasury Department and the IRS requested comments regarding whether a higher ownership threshold should be permitted in such years, but noted the complexity of creating a special rule. Increasing the ownership threshold to 50% for purposes of the control test would provide additional capacity for an exempt organization's interest to increase as a result of actions taken by other partners, without requiring any additional special rules. Increasing the ownership threshold to 50% also reduces the likelihood that an exempt organization's interest will fluctuate above and below the threshold from year-to-year, and thus reduce the administrative burden of holding a partnership interest that is a QPI in some years but not in others.

IV. Summary

Although we would prefer the final regulations to adopt a rule that treats all investments in limited partnerships as one trade or business so long as the exempt organization is a limited partner, we believe the ownership threshold for purposes of satisfying the control test should be a greater than 50% capital interest. This percentage is consistent with other areas of the Code and maintains ease of administration from an IRS perspective. This percentage would also serve to decrease the administrative burden on the exempt organization by reducing the number of investment partnerships required to be analyzed in order to determine the trade(s) or business(es) and NAICS code(s) of the limited partnership for reporting on Form 990-T, presuming this information is even available. It would also minimize the unique tracking and reporting considerations in situations where capital percentages fluctuate as other partners enter/exit the limited partnership.

We appreciate your consideration of these comments and look forward to responding to whatever questions you may have.

Sincerely,

Shannon Cullinan
Executive Vice President
University of Notre Dame

Mark Krcmaric
Managing Director & Chief Operating Officer
University of Notre Dame, Investment Office

University of Notre Dame du Lac
Notre Dame, IN